A year ago I told investors to sell technology stocks and reinvest in long-term Treasury bonds. That bet turned out very well on both sides: The tech-heavy Nasdaq 100 index is down more than 30% in 2002 while the total return for 10-year Treasurys has been about 18% (and even more for longer maturities).
For 2003, I predict that the great bull ride in Treasurys is over. It’s a good idea to take profits there. But that doesn’t mean it’s time to get back into tech stocks, since I believe there are much better investments for the coming year.
First, let’s talk about why it makes sense to sell government bonds now. Over the past month the Federal Reserve has made it crystal clear — through both public pronouncements and through their actions — that it understands the risk of continued monetary deflation and stands ready to do whatever’s necessary to prevent it. After years of not-so-benign deflationary neglect (an issue that I’ve addressed frequently in this column), Greenspan & Co. has finally decided that it dare not let the U.S. go the way of Japan; that is, into a deflationary spiral of falling consumer prices, collapsing asset values and obsessive cash hoarding.
That’s great news for the economy — and, if I may say, it’s about time. But it’s bad news for Treasurys. With deflation, money becomes more valuable relative to “things.” And with deflation, expanding real debt loads trigger bankruptcies. The instruments that promise to pay out a lot of cash in the future with no default risk are the most precious of all — and that description fits Treasurys perfectly. As investors became more and more cognizant of the threat of deflation, Treasurys just kept on becoming more and more valuable. But with the Fed’s new commitment to fighting deflation, there’s little reason to think that Treasurys will go any higher from here.
However, just because the motive power of the great Treasury bull market has been extinguished doesn’t mean that we necessarily stand at the beginning of a symmetrically great bear market. Unless the Fed replaces deflationary risk with inflationary risk, Treasurys may very well just stay frozen pretty much where they are right now over the next year. Could a new inflationary risk arise? Sure. It’s happened before, and we should be on guard against it. But I’m satisfied for the moment that the Fed is appropriately focused on stabilizing the value of the nation’s money, and will likely succeed in that task at least during 2003.
So if Treasurys get the short end of the stick due to the demise of deflation, then what wins? The answer might surprise you, but it shouldn’t.
The end of deflation means the removal of a major risk factor in the economy. Businesses will now feel more confident about making long-range investments with the expectation that the value of the nation’s money — a value in which those investments are denominated — won’t arbitrarily change. And with cash less tied up in deflationary hoarding, credit liquidity will flow and bankruptcies will be fewer. That new confidence and liquidity will help those areas of the market that were most damaged by fear and illiquidity. Personally, I think one of the biggest beneficiaries will be the market for high-yield, or junk, bonds.
Even if long-term interest rates begin to rise somewhat in 2003, my guess is that junk bonds could be the best-performing asset class of the year. That’s because junk prices are far more affected by default risk than they are by interest rates. During the past few years, junk bonds have been hammered by increasing fears of default. As a result, the spread between junk yields and Treasury yields has soared to near-historic levels — that simply means that junk investors have demanded extraordinarily high premiums for taking any risk. Now, as that risk is alleviated, junk yields can come down even if Treasury yields rise. And when junk yields come down, their prices commensurately rise.
As for stocks, it should be a good year overall. Equities in general are cheap in relation to reasonable earnings expectations. Scared investors have driven stock prices to extraordinarily low levels. As the end of deflation takes some of the fear out of the market, overall stock prices could easily rise anywhere from 10% to 25% this year for that reason alone.
While I can say that for stocks overall, I can’t say the same for technology stocks. Yes, these stocks were among the worst victims of deflation. Their high prices in 1999 and 2000 were based, in part, on investor confidence that Greenspan would maintain his excellent track record of delivering monetary stability — but the Fed chairman failed big time, and the technology-led boom imploded, taking richly valued tech names into a monstrous bear market.
Yet despite all that, tech stocks aren’t as deeply undervalued as the rest of the market. In fact, by my model, technology stocks are actually slightly overvalued — they’re the one and only sector of the market about which I can make that observation. So as the relaxation of deflation-driven fears heals the psychology of the market, tech stocks stand to benefit the least.
I wish it wasn’t so. I wish I could tell you that bold new initiatives in tax, regulatory or trade policy — or some fabulous new killer app — promised to revive the late-1990’s dream of a tech-led global boom. But nothing even remotely like that is happening. All the “stimulus” proposals being bandied about in Washington right now seem targeted at the Old Economy (believe me, struggling technology firms couldn’t care less that there may be a tax break on dividends in the works). And as far as I can tell, there isn’t any Next Next Thing on the drawing boards in Silicon Valley.
So my advice for 2003 is simple: Think hard about taking profits in Treasurys, and start assuming a little prudent risk. Consider junk bonds, but be sure to spread your exposure as broadly as possible (diversified high-yield-bond mutual funds are a great option). And move back into stocks, but stick to the boring ones — industrials, health care, financials. If you absolutely must buy tech stocks, then at least own the largest and financially strongest companies.
2003 will probably be a good year — provided you don’t let wishful thinking about what worked in the late ’90s seduce you into making the wrong bets.
Originally published on SmartMoney.com