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Martin T. Sosnoff Headshot

Trade in Your Bonds for Equities

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Every time I hire an outstanding Egyptologist to guide me through the ruins I end up canceling my trip -- for good reasons. Now it's the 81-year-old despot, still black-haired, going on 85 and how many face lifts? Last year, a group of German tourists were savaged by terrorists. Recently, a busload of foreign visitors crashed on a winding road with multiple fatalities.

More and more, I sense the world is busy, maybe too busy and prone to accidents. The financial world is so interconnected that when China's monetary authorities notch up interest rates to fight inflationary excesses our Big Board shudders. Turmoil in Egypt triggered a $6 spike in oil futures over 2 days. Talk about butterflies flapping their wings on distant continents!

When markets roil in pain, missing geopolitical upsets in the Mideast, I force myself to press trading desk buttons and buy reciprocal beneficiaries. Egypt's pain is oil's gain. In case you missed it, both Schlumberger and Halliburton spiked 10 percent. Oil reserves outside the Mideast just turned more strategically valuable. Drilling is bound to accelerate elsewhere.

I hate this daily noise level, but I've learned not to overreact and go on with my life, tuned into the mighty flow of Ole Man River, the long term trends lurking beneath the surface of choppy waters.

Some fifty years ago, Sidney Homer, Solomon's research partner, published his annual supply and demand for funds study that dealt with the bond market. It couldn't encompass wars and financial panics but was a good indicator of where the bond market was headed. Later on, Henry Kaufman took on this responsibility. Traders at Solly ignored these term papers as too academic, but this document was distributed to the Street and eagerly awaited by all of us.

Everyone today dissects each mumble of Federal Reserve Board members and makes decisions based on the course of the dollar, interest rates, inflation and emerging markets dynamics. I don't see much work done on the supply and demand for funds available to our stock market. The Street tracks volatility and the correlation of specific stock market groups to broader indices like the S&P 500, but this is pure noise level stuff.

Stats I look at suggest huge money streaming into equities from institutional and individual investors. Forget foreign money which is volatile and invariably comes in late, thereby accentuating bull markets but is not a significant variable. Changes in flows mount into trillions of dollars, enough to move Big Board valuations higher. Margin credit is insignificant, maybe $500 billion in a market valued near $15 trillion. This even with interest charges relatively insignificant for well heeled investors, no more than 1 percent.

The quarterly net flow into financial assets during the bear market turned from a $200 billion positive to a negative number. Individuals, at least, handled themselves conservatively, raised cash, didn't tap margin credit and plowed money into bond funds, municipals, and even paid down outstanding debt. Meanwhile, state and local debt rose inexorably this past decade as did Federal debt and Fanny and Freddy's mortgage pools. But, the cost of debt service for the government is half what it was 10 years ago and debt service as a percentage of GDP rose only 2 percentage points to 18 percent from 16 percent. Politicians rarely dig down into such pivotal numbers.

Even though real short term interest rates turned negative the past few years, individuals raised cash holdings to 40 percent of financial assets from 30 percent. Only in the mid-seventies and early 1980's was cash as much of 60 percent of assets. Then, short term interest rates ranged as high as 15 percent under Paul Volcker's reign as Federal Reserve Board chairman. Those days gone, but not forgotten.

Currently, there's a sea charge in asset deployment under way by individuals and institutions. Money is coming out of bond funds and municipals and flowing into equities. The only fixed income sector holding up is the junk bond category, where yields to maturity of 7 percent or better are available on single B credits. Even BB credits with yields of 5.5 percent are holding firm despite the treasury market's decline.

Unless 10-year Treasuries spike to the 4.5 percent level shortly (not my call) the high yield market could be almost as attractive a sector as it was over the past 24 months and give stock market indices a run for best asset class, again.

Over the past six years, private pension funds took bond holdings up by $1 trillion, but this move is played out and capital is moving back into stocks. Equities dropped from 60 percent of assets to below 40 percent at the market bottom. Fixed income investments had risen to as high as 30 percent of assets from a normalized 20 percent.

Equities at the top of the market in 2007 reached about $19 trillion and bottomed at $10 trillion. Cash for all institutional investors and individuals over the past decade rose form $5 trillion to $9 trillion, a huge amount needing reinvestment into higher yielding paper. Even the Big Board yields over 2 percent and is seeing serious payouts from tech houses like Intel and Microsoft to be followed by Cisco and perhaps even Apple, presently sitting on its $70 billion boodle.

Equities, normally 70 percent of private pension fund assets, even after the monstrous market rally now stand at 60 percent of assets. Fixed income investments remain at 40 percent of assets, normally closer to 20 percent. Financial assets held by individuals have rebounded to $25 trillion from approximately $20 billion at the market's low point.

I see at least $5 trillion in pension fund and individual assets reallocating to equities over the next 24 months from cash holdings and bonds. Unless short rates rise markedly over the next 12 months, the reallocation from cash alone could reach as much as $4 trillion. Fixed income investments seem too high at $9 trillion vs. a normalized level of $5 trillion so my $5 trillion asset reallocation number could be conservative.

Obviously, inertia is a powerful force and what is sensible and logical doesn't always happen. Consumer confidence is rising so this is a plus factor, but home prices need to perk up, too. After all, half of all family wealth resides in home ownership. A weak dollar is good for the stock market up to a point, but negative for fixed income investments.

The world is witnessing serious commodity inflation in oil, copper, iron ore and grains. All this could lead to tightening by central banks, worldwide. A reversal in Federal Reserve Board policy emphasis could happen sooner than the bond crowd anticipates. Nobody expects Fed Funds above 1 percent well into 2012. Money may stay in short term holdings longer than I expect.

If 10-year Treasuries pierce through the 4 percent yield level it could inhibit capital flows into equities. Market pundits would take down their projection of a mid-teens price earnings ratio by a couple of notches. There could be a reverse flow out of equities into bonds, but I rate this as a low probability.

Net, net of this supply and demand funds analysis for the stock market, we should see at least a couple of trillion flowing into stocks, maybe more. This sum is a big number for a market valued around $15 trillion. I wasn't smart enough to buy gold which thrives on geopolitical unrest, but I did put new money into commodities, namely oil, and coal, copper and iron ore.

If anything, growth stocks turn marginally more attractive, even richly priced properties like Amazon and Baidu whose top lines mushroom for years to come. Both Apple and Google posted way above consensus numbers. Somebody besides me must care, sooner or later. Apple now trades above its price point when the Steve Jobs bomb shell hit the tape.