A few months ago, Federal Reserve Chairman Ben Bernanke made headlines when he coined a new catchphrase by describing the economic outlook as “unusually uncertain.” Although he was talking about the economy, his remark applied with equal force to the investment markets. Still, since the market turn in March 2009, the S&P 500 was up 67 percent through November 2010,1 global stocks posted similar results and bonds produced some banner performance — but in all cases with notable volatility along the way. So Bernanke's judgment continues to define investor sentiment, though to a lesser degree.

Are We in a Recovery?

Although the Great Recession was declared officially over as of June 2009, it doesn't feel that way to many investors. Many traditional measures of well-being continue to appear weak. Unemployment is stuck at a stubbornly high level. Much of the housing market is still mired in the doldrums. The government has felt it necessary to inject trillions of dollars of fiscal and monetary stimulus into the economy (most recently the Fed's second massive purchase of Treasury bonds, so-called Quantitative Easing 2, or QE2). And after a powerful surge in 2009, the stock market has been oscillating between strong rallies and periods of pronounced weakness.

Nonetheless, we're forecasting gross domestic product growth for 2011 at a solid 3.5 percent globally and 3.8 percent in the United States.2 Further, manufacturing and other industrial indexes are encouraging for much of the developed world, credit is flowing more easily than in the last couple of years, productivity and inventory levels suggest a rebound and the emerging markets are humming; in fact, they have become the drivers of global growth. Their companies are reinvesting more aggressively than those in the developed world, and their consumer demand for domestic and imported products is growing as their middle class expands. The data are confusing, so it's no anomaly that investors are feeling equally as confused.

Cash is a Siren Song

Indeed, many investors remain on the sidelines. The problem is, three-month Treasury bills are yielding about 0.15 percent as of this writing — a number so meager as to be dwarfed by the latest annual consumer price index figure of 1.2 percent, producing a negative real yield. Investors who flee to the “safety” of cash aren't only earning virtually zero income, they're also losing purchasing power steadily. Many investors acknowledge that they don't intend to stay in cash forever, but figuring out when to take the leap back into stocks is incredibly difficult. As long as markets are weak, investors feel vindicated and stay in cash. If markets rise, then investors may feel even less comfortable investing at higher prices. Cash provides the security of liquidity and a stable price, but it's easy to miss the unpredictable bursts of return that typify stock recoveries.

Bonds: The Risk of Rising Rates

Bonds remain the “anchor to windward” in a well-constructed portfolio and indeed the currently steep yield curve has made intermediate-term bonds even more attractive (relative to cash) than usual — but there's a catch. In mid-December, the 10-year Treasury yield was hovering above 3 percent; some 30 years ago it reached as high as 16 percent, and many investors are worried that rates have virtually no place to go but up. Indeed, as of this writing, rates have recently moved up; when that happens, bond prices fall.

However, for intermediate-term (roughly five- to seven-year maturity) bonds, the damage may be less than investors fear. For example, the last time the Federal Reserve raised the federal funds rate was in 2004: a 4.25 percentage point hike over two years. Even during that period of interest rate increases, the rise in yields at most intermediate bond maturities was far more muted: five-year Treasuries, for example, went up by only about 1 percent, mitigating the price damage.3 Furthermore, it's hard to imagine interest rates rising very dramatically without fear of sharply higher inflation — a condition that doesn't appear to be on the near horizon.

Creditworthiness of Issuers

The financial condition of some borrowers is a worrisome topic for many investors in municipals and certain taxable bond sectors as well. In many cases, as we see it, the fears are exaggerated. On the municipal side, the shortfalls vary by state and locality, but most budget officials have the resources and the determination to raise taxes and cut spending where they must: They're making those hard decisions now. Revenues are already inching up as the economy slowly improves — and the states are hardly drowning in debt. In most cases, debt service represents only 4 percent to 8 percent of the budget.4 The default rate among municipal bonds has historically been tiny, and we don't expect this market to break the mold.

The sovereign debt crisis in Europe is another matter and requires careful monitoring. The key risk, as in a similar episode earlier in 2010, is contagion for equity and bond markets in Europe and around the world. However, the International Monetary Fund and the European Central Bank acted quickly last time and once again will likely do everything possible for weaker economies to make needed adjustments.

Among taxable bonds, the issue is clear-cut: Are you getting paid for the risk of exposure to sectors other than government bonds? The answer, of course, depends on the sector and the bond. But in general, investment-grade corporates — and even some high-yield issues — remain attractive, although their yield spreads against Treasuries have narrowed. And despite uncertainties in much of the mortgage market, select super-senior-tranche commercial mortgage-backed securities were offering some 300 basis points of yield over comparable maturity Treasuries, on average, as of Oct. 31.5

In addition, not all risks surface at the same time. For example, if the economy remains in a relatively slow-growth phase for a while longer, the turn toward rising interest rates will be postponed. Or if interest rates are driven higher by a strengthening economy, credit risk will diminish, which could increase bond prices. This scenario would also bode well for the equity portion of an investor's portfolio.

Stress Precedes Bull Stock Markets

Turning to equities, we're struck by a long-term relationship between volatility and the subsequent performance of stocks. The worst bear markets have been preceded by periods of low volatility — not really a surprise, since investor complacency is a breeding ground for the emergence of risk. Today, the situation is quite otherwise, with investors unsettled and volatility twice as high over the past two years as the long-term average.6 Historically, high volatility cycles have often preceded the best periods of stock performance. And so while the risks today are real, we would also note that stress fuels the emergence of countervailing forces: the catalysts for full economic recovery and a rising stock market.

Change in Mood?

As we've suggested, today's environment is still a showcase for risk aversion. Investors continue to overpay for safety. Businesses remain wary about spending money, segments of the financial sector may not be out of the woods yet, banks have housed an unprecedented trillion dollars of excess reserves at the Fed7 and the extent of the government intervention worldwide has added a new layer of uncertainty for investors. But with low expectations baked into many forecasts, any change in those conditions may herald a return to confidence. And indeed corporate earnings are back to prior peaks — with most continuing to surpass analysts' expectations. Consumer spending is picking up, and after taking a sharp downward path, capital spending has turned for the better as well. If these trends continue, they could be a powerful force in boosting economic recovery.

Corporate Cash Spells Opportunity

If there's one factor we would single out, it's the generation of cash by companies in every region of the globe. In the United States, for example, cash as a percent of assets reached 7.4 percent a few months ago: a half-century record.8 Too many companies continue to hoard that cash, but the climate is changing, and whether the cash is used to consummate acquisitions, reinvest in businesses, buy back shares or increase dividends, the result for the economy and for the prevailing investor mood should be positive. We estimate that as of third-quarter end, close to 30 percent of the S&P 500 stocks had enough free cash flow to double their dividend if they so chose.

And this is in the context of a classic market disconnect. In the United States, the S&P was selling at about twice book value at the end of November, rivaling some of the lowest levels in decades. Overall, the equity risk premium — the potential extra return from owning stocks over bonds — was in the range of 7½ percent in mid-fall.9 That compared with a long-term average of 4 percent and represented nearly a 50-year high. The situation was similar in much of the developed world.

Time for Optimism — and Caution

And so we live in interesting times. The Fed chairman correctly highlighted today's uncertainty, but the tenets of investing haven't changed. While stock market risk is above normal due to uncomfortable fiscal and monetary conditions, the return potential of stocks is also above normal. Meanwhile, bond risk and return potential are both below normal (although significantly better than cash). Putting this all together, we think investors should be at their long-term strategic allocation to equities. At the same time, in these markets we think it's good advice to stay well-diversified: A mixed strategy is appropriate for mixed times.


  1. Standard & Poor's and AllianceBernstein.
  2. AllianceBernstein.
  3. Federal Reserve, Municipal Market Data Corp. and AllianceBernstein.
  4. U.S. Census Bureau and AllianceBernstein.
  5. Barclays Capital and AllianceBernstein.
  6. Robert Shiller, U.S. Department of Labor and AllianceBernstein.
  7. Federal Reserve Board.
  8. Excluding financial companies; U.S. Federal Reserve and AllianceBernstein.
  9. Bloomberg, Standard & Poor's, and AllianceBernstein. Note that this represents a research conclusion, not a guarantee of any specific relationship between future stock and bond returns.

Gregory D. Singer is director of research for the Wealth Management Group and Dianne F. Lob is chair of the Private Client Investment Policy Group of Bernstein Global Wealth Management. Both are based in New York


Two's Company … Five's a Crowd

This Belgian movie poster of “Une Nuit à l'Opera” (“A Night at the Opera”) (84 cm. by 60.5 cm.), was sold at Christie's Vintage Travel Poster Auction in London on Dec. 1, 2010 for $4,668. The 1935 film was one of the first Marx Brothers films to have an actual story and not, as producer Irving Thalberg said, “build insanity on insanity.”