Let the yield curve point the way.
Despite varying headwinds from uncertain economic news and snarling legislative stalemate, the stock market keeps tacking upwind. Entering March, it was slightly ahead for 2010 as it neared the anniversary of the remarkable rally that began in March of 2009.
The memories of its fall from grace beginning in 2007 seem dominant with most investors. That is certainly understandable as that signaled the beginning of a recession and the end of excesses ranging from easy lending to GM”s recently deceased Hummer. Prior to this abrupt descent, the global economy had become much more closely knit and the actions taken by the world’s central banks were unprecedented in their coordinated and forward looking reach.
The recovery is thus underway although not as fast as anyone would like. One byproduct of these steps is an anomalous pattern of interest rates with short-term secure obligations like treasury bills paying almost nothing while longer term or less prestigious securities must offer higher rates.
Notwithstanding all the heavy breathing by media commentators trying to get attention, U.S government bonds are still universally regarded as the safest things around. They typically trade in a rising yield curve with longer maturities bearing higher rates. This is logical as investors realize that longer time periods give more opportunity for uncertainties to develop, including the possibility of increases in interest rates.
Occasionally, the yield curve can become inverted with short-term rates higher than long-term, reflecting a reading by investors that the economy is slowing or even declining. That is hardly the case today; in fact the yield curve is remarkably steep, indicating the start of an economic expansion.
Historically, the 20-year Treasury bond yield has averaged about two percentage points higher yield than three-month Treasury bills. Recently, this gap widened to the extent that 10-year Treasury notes yield almost three percent more than 2-year notes, a new record and a solid predictor of a vigorous economic recovery.
In this environment of low interest rates, low inflation and a developing economic recovery, I continue to recommend stocks in companies that can continue to grow sales and earnings in this challenging business environment. Sadly, unemployment gains lag a business recovery and I fear that conventional retail companies and the housing sector will have a slower path back than companies in more business-related suppliers like much of the tech sector.
With many investor memories fixated on the shocks before the rally began, stocks are still trading in many cases at quite reasonable valuations with even better buys developing on overreactions to superficially disappointing company news. Telvent (TLVT-$30), for example, announced good earnings accompanied with a conservative forecast, and its stock dived, exacerbated because its headquarters are in Spain and investors panicked on headlines about Spain’s fiscal problems.
Spain suffers from an overly aggressive recent expansion of real estate construction and lending, which sounds familiar, and Telvent’s global information technology business is not at issue. The company provides products and services for global power grids, energy controls, infrastructure, transportation, and agriculture, and other sectors with growing demand. It is trading at a modest 14 times 2010 earnings and yields 1.7%.
Investors seeking higher returns can use bond funds that combine higher yielding longer-term bonds with short-term bonds. Credit Suisse Income (CIK-$3.40) yields 9% and its holdings have an average maturity of only 5 years. Annaly Mortgage (NLY-$18) and Chimera Investment (CIM-$4) must be nimble and quick as they borrow short-term while investing long-term. They are thus only suitable for more nimble investors but they are paying over 16%.