Fleeing Bonds for Equities Again

01/11/2010 12:00 pm EST

Focus: MARKETS

James Oberweis

President, Oberweis Asset Management, Inc.

Jim Oberweis, editor of The Oberweis Report, says another good year in stocks will be powered by investors’ flight from bonds to equities as the specter of inflation appears.

We believe that 2010 will be another good year for equities. In contrast to 2009, when cheap valuations drove our bullish conviction, our 2010 prediction is based on OOB—“Out of Bonds.”

Here’s the short of it: way too much money has flowed into bonds in this risk-averse world. Bill Gross’s Pimco Total Return Bond fund broke the record on December 17th as the largest mutual fund in history with $202.5 billion in assets.

It’s not terribly surprising considering the backdrop. We just finished the worst decade ever for stocks in more than 200 years of market history, with the Standard & Poor’s 500 returning—1.0% annualized over the last ten years. It was one of very few decades over which stocks lost money.

In comparison, bonds returned an average of 5% to 8% annually, depending on the sector. It should come as no surprise that bond funds are at record asset levels. Investors chase returns (and run from losses).

According to Ibbotson & Associates, long-term Treasuries have returned an average of 5.7% per year since 1926. Current yields are 4.61%, or less than most other periods in history even after a pop in 2009.

Admittedly, inflation has been muted, but will it continue? Data from Ibbotson & Associates indicates that inflation since 1926 has averaged 3.0% per year. Today’s ten-year inflation expectation imputed by bond yields is 2.4%, or less than [the] historical average. This figure is simply the difference in yield between ten-year Treasuries and ten-year TIPS (Treasury Inflation Protected Securities, whose yields adjust for inflation).

We believe that periods of quantitative easing (a really fancy term for printing money) tend to be inflationary. Periods of massive easing (or printing boatloads of money) tend to be very inflationary. Mark our words: Inflation is coming, and owners of long-term bonds will lose money. We believe that as bond returns begin to languish, money will flow from bonds to stocks, which tend to be more resilient in times of inflation.

A relatively benign increase in investor appetite for stocks can make a surprisingly significant difference in stock prices, and we believe you will see it play out in 2010. We also believe that higher inflation expectations in the US will put enormous pressure on the Chinese to allow the yuan to appreciate against the dollar. Expect to see the value of the Yuan rise by 5% or more in 2010.

We expect the Standard & Poor’s 500 index to appreciate by more than 10% in 2010. We expect the Russell 2000 Growth Index to return north of 12%.  The ten-year market-imputed inflation forecast by the end of 2010 will rise from 2.4% to at least 3.0% and perhaps considerably more. We expect Treasury bill rates to rise from their present rate of 0.01% to 1.25%.

We expect bonds to deliver losses and would recommend shorting 30-year US Treasury bonds right now. Bonds stole the spotlight in the non-roaring 2000s. In the 2010s, equities will regain their throne.

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