Why equities investors need to watch bonds too

Legendary investor Jeremy Grantham, co-founder of GMO. Picture: James Croucher

Jeremy Grantham, the legendary former bond market king at mega fund manager GMO, has described the current market as “a fully fledged epic bubble”. Many have also asked whether we are in the midst of a new dotcom bubble — the endgame of which boomers have had the mixed pleasure of experiencing, but millennials have not.

Still, I have challenged this view for three reasons:

First, bubbles in specific sectors of the market, such as the “buy now, pay later” sector in Australia, can inflate and collapse in isolation, and without disrupting the rest of the market, provided the assets crashing aren’t on the balance sheets of systemically important financial institutions.

Second, the overextended valuation of the broad market is being driven by a heavy weighting to five global businesses.

And finally, when compared to ultra-low bond rates, a simple calculation reveals the equity market is roughly fair value.

Against this backdrop, bond rates have been fluctuating in a rather one-sided direction — that is, upwards.

And that’s not good for asset prices if it persists.

Indeed, history shows that the initial surge in bond rates is welcomed by the stockmarket as it reflects strengthening economic growth.

But as economic growth stabilises, any continued rise in bond rates becomes decidedly unwelcome and shares have a “correction”. 

Today, rising bond rates are generating no cause for concern. Just last week Bank of America revealed global equity funds recorded record inflows approaching $US60bn ($77bn).

What is concerning, however, is the frequency with which rising prices are justified with flawed if not circuitous arguments. 

Active ETF manager ARK Investment Management’s CIO, Cathie Wood, in a recent interview with The Wall Street Journal, said that the 10-fold increase in Tesla’s share price over the past 12 months was a reflection of the market’s maturing understanding of the company’s exponential growth opportunity. 

Great risk emerges when investors take their cue from share prices. A rising share price may or may not be a reflection of a better understanding of the underlying company’s prospects. However, when a car manufacturer’s share price is trading at a market-cap-to-vehicle-sold multiple almost 50 times higher than the next nearest competitor, then an understanding of the rate of growth and ultimate size required to justify the price is required. 

Without question we are in a bull market and experiencing bubbles in some segments of both the market and economy due in part to casinos being closed due to COVID-19 restrictions.

Importantly however, all the optimism surrounding innovation, revenue and earnings growth rates, as well as the long runways for growth for innovation, is being fuelled by those ultra-low bond rates, support for which comes directly from central banks.

Ultimately, investors who fear a correction in shares need only to watch those bond rates and the effectiveness of central bank efforts to keep them suppressed. 

When bond rates rise, the present value of future cashflows decline and the biggest impact is felt by companies whose earnings are “potential” rather than “actual”.

Consequently, given that the largest portion of the paper gains investors have accumulated has been through companies yet to generate a dollar of profit, the present value calculation needs to be kept firmly at the forefront of their thinking. 

US 10-year Treasury bond rates now stand at 1.29 per cent, which is materially higher than the 0.52 per cent they traded at a year ago. To put the change in perspective, it is worth understanding the impact of this change in bond rates on a dollar of earnings generated five years from now, 15 years from now and 20 years hence. 

At a bond rate of 0.52 per cent, a dollar earned in five years’ time is worth 97.4c today. At 1.29 per cent that dollar earned in five years’ time is worth 93.7c, representing a decline in present value of 3.8 per cent.

At a bond rate of 0.52 per cent, a dollar earned in 15 years’ time is worth 92.5c today. At 1.29 per cent that dollar earned in 15 years’ time is worth 82.5c, representing a decline in present value of 10.8 per cent. 

In other words, as rates climb, the negative impact to valuations is felt most acutely for those companies whose earnings are well out on the horizon. 

Bubbles will inflate and deflate in blissful isolation, and without affecting the rest of the market.

If bond rates keep rising, however, the rest of the market needs to watch out.

Roger Montgomery is founder and chief investment officer at montinvest.com