In 2012, something’s gotta give

Commentary: Stocks, bonds, the euro, China — all under pressure

Because if the markets around the world are to be believed, this is the year when something’s gotta give.

Sorry to be gloomy at this festive time, but there it is.

Will it be U.S. stocks? Could be. They are already trading at lofty levels. Shares are about 21 times average earnings for the past 10 years, says Yale economics professor Robert “Irrational Exuberance” Shiller. That’s about 25% above historic norms, he says. This measure has a very record of predicting future returns.


A similar picture is borne out when you compare stock prices to the cost of replacing company assets, the so-called Tobin’s q measure first discovered by the late economist James Tobin. This measure, too, has an excellent record of predicting future returns.

Both are saying gloomy things for stock investors.

Of course, maybe they’re wrong. Maybe company profits will keep on booming. It’s hard for companies to boost margins by slashing more costs, of course. They’ve already laid off everybody they can (try to reach a customer service call center if you don’t believe me). But maybe the economy will start to pick up. Maybe a nice new boom will come along and rescue stocks.

The only problem? If that happens, you had better look out below in the bond market.

Right now U.S. Treasury bonds are positioned for gloom. Ten year Treasury bonds are yielding less than 2% and 30 year bonds less than 3%. By the standards of modern times these are very, very low.

A good, old-fashioned resurgence in growth is likely to knock them to the wall. Investors don’t want to hold paper paying 2.9% a year for 30 years when they can earn a lot more on stocks. For that matter, they don’t want to hold that paper if inflation picks up.

A slump in Treasury bonds would hit corporate bonds hard, too, as they are generally priced in relation to Treasurys.

It’s nothing new for the stock market and bond market to disagree, but watching the bond market argue with itself is another matter. While regular U.S. Treasury bonds are priced for a sluggish economy with steady or even falling prices, inflation-protected Treasurys — so-called TIPS bonds — are braced for inflation. These bonds have now locked in negative “real” yields — in other words, yields adjusted for inflation — over the next decade. Historically, these TIPS bonds have tended to yield inflation plus about 1 to 2% a year. Bonds with negative real yields almost guarantee instead that investors will lose purchasing power.

The prices of these bonds most make sense if investors expect to see stagflation — poor growth and quickly rising prices. For very technical reasons, they might also make sense if investors expected a total, 1930s-style economic collapse, with plummeting prices.

The markets can’t all be right. In 2012 we can’t see a good old-fashioned boom with rising employment and falling spare capacity (which is what the stock market wants), a slump with tons of spare capacity and flat prices (which is what the regular bond market wants) and either a slump with no spare capacity and surging inflation or a 1930s meltdown (which is what TIPS seem to want).

Looks like something’s gotta give.

Now look overseas.

Is the euro in deep trouble?

The bond market says it is. Despite the recent Santa rally in bonds over there — a rally driven by politics — the bonds for Greece, Italy, Spain, Portugal and Ireland are all flashing warning signals about those countries’ finances.

Meanwhile the currency markets seem to think otherwise. The euro is holding up at around $1.30 to the dollar. Gold has come down from its peak.

It’s hard to see how they can all be right.

If the crisis gets worse, watch out for U.S. stocks (see above) as well as other risk assets.

The euro will almost certainly come tumbling down. It’s currently $1.30 to the dollar — down from last summer’s highs, but still pretty lofty for a currency in crisis.

A falling euro would help European companies, by making their exports to emerging markets and the U.S. cheaper. The problem? That will hurt competing U.S. exports.

Oh, and then there is the small matter of China. The locomotive of the global economy is relying on a housing mania and a gigantic capital investment boom that currently soaks up nearly half the entire gross domestic product.

Maybe that goes on indefinitely, until every inch of China is paved in concrete, every Chinese peasant lives in a luxury condo with valet parking provided by other Chinese peasants, and every town there has high-speed WiFi connections and bullet trains and monorails.

Maybe it’ll all work out.

But a lot of investors are looking at the Chinese economy and saying: You know what? Something’s gotta give.

Brett Arends is a senior columnist for MarketWatch and a personal-finance columnist for the Wall Street Journal.

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