Trading News

The Financial Times ran a story of profound importance recently, but it seemed to go largely unnoticed.

The U.K.-based newspaper reported that brokers including Merrill Lynch believe that stocks are becoming safer long-term investments than government bonds. This corresponds with some of my own research and helps explain recent price action in the S&P 500.

It's difficult to express what's happening because I believe that we are nearing a true paradigm shift in the world of finance and investing. Attempting to make specific predictions is a fool's game, but certain factors are lining up in a way that suggests we're near the beginning of a new bull market. It will have its own causes and attributes that will unfold over a period of years rather than months.

Put simply, I believe that stocks are underowned and that Treasuries are overowned. We are nearing a point where the marginal dollar will increasingly flow into equities over bonds and where money will gradually migrate away from "safe assets."

First, it's important to realize that Treasuries have enjoyed the greatest bull market in history since 1980, with yields consistently ticking lower in good times and bad. They now seem to be near levels where they can fall no further. (The Fed can't push rates much lower, and the 10-year Treasury yield seems to have formed a double bottom in the last two months.)

Second, government bonds are now showing all signs of a bubble in its final stages, with people plowing money into them indiscriminately. Supply has surged in response--just the same as Latin American debt in the late 1970s, dot-com stocks in the late 1990s and residential mortgages in the middle of the last decade.

Third, assets similar to Treasuries have already started to fail. Remember Fannie Mae and Freddie Mac? Also, look at sovereigns in Europe and municipalities in California. Mortgages are another case study because they had been and supported by the federal government since the 1930s. Roll back the clock 10 years, and none of those assets were priced based on credit risk; they were based only on interest-rate risk.

In some ways, the crises of the last five years resulted from nothing more than the market waking up to the credit risk in mortgages and sovereign debt. But that consideration of credit risk has not yet been applied to Treasuries. How many investors, after all, analyze the creditworthiness of the U.S sovereign before buying bonds? (Answer: None.)

There is no denying that U.S. public institutions have become increasingly weak--just look at the state of Congress and the budgetary process. In the last decade, government spending has surged to about 140 percent of revenues from 110 percent while total debt has almost tripled.

In the same period, companies have done the exact opposite and grown increasingly strong. Their profits have risen from 3 percent of GDP in 2002 to more than 8 percent now, and they're better capitalized than at any other time since World War II.

In fact, a longer-term view is important because the 20th century was a period of powerful governments and weak companies. The trend started during the Great Depression and continued during WWII and the Cold War, when the state in various ways promoted innovation and investment in such areas as aerospace, medical research, and technology.

But we must never forget that modern capitalism actually began in the 19th century. That's when companies and private individuals ruled the world--there were no Treasuries.

Something similar seems to be taking shape again. It doesn't mean to chase stocks at the highs, but it does mean to buy the dips and enjoy the ride.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of July 18.)