Stocks Will Benefit

Investors disappointed with the stock market's sub-par performance have piled into other asset classes. One such red hot asset class is the bond market, which has been attracting a lot of investment dollars, largely at the expense of stocks.

But that sizzling rally may be nearing its end. No prizes for guessing which asset class will benefit from the coming bond bust.

Why is there such a negative outlook for the big bond market? Well, the core rationale behind that rally, particularly in the Treasury bonds, can't stand up to a critical review. The goal here is to persuade you that bonds have had a great run, but their best days are behind them. Get ready for the stream of money into the stock market. Stocks are the place to be!

While there are other factors at play as well, the primary driver of this Treasury bond rally is a very pessimistic view of the US economic outlook. Purveyors of this view foresee the U.S.'s path to be very similar to Japan's in the 1990s. The Japanese economy was stuck in a spiral of torpid growth and deflation in that decade. The dispute goes that Japan's 'lost decade' was preceded, as is the case with the U.S. now, by the bursting of a real estate and banking bubble.

It is an acceptance that the U.S. economy is faced with a number of challenges, it is not alleged that we are headed towards a deflationary phase. With the yield on the 10-year bond now at a multi-decade low in the 2.5% neighborhood, it simply can't be compressed anymore. When you see that the dividend yield on the 30-stock Dow Jones index exceeds the 10-Year bond yield, you know that the Treasury bonds are in uncharted territory.

The U.S. is No Japan

While there are many similarities between the U.S. today and Japan in 1990, there is one critical point of difference between the two – the U.S. Federal Reserve. The Fed's conduct to date clearly shows its deep perception of the Japan scenario. With Ben Bernanke at the helm, the U.S. has the most earnest student of Japan-like situations in command. His 'Helicopter Ben' nickname is closely tied to his strong views on the subject.

We have clear facts that the Fed has internalized two key lessons from Japan's experience in the 1990s. First, be aggressive and non-dogmatic in tackling the issue head-on. And second, heal the banking sector as promptly as possible.

The Bernanke Fed has been exceptionally aggressive in its response. They not only cut rates to near zero, but committed themselves to keeping them there for an 'extended period'. And they have been about as unconventional and non-dogmatic as any main central bank has ever been. In fact, many commentators have been critical of the Fed for being too aggressive in the use of its balance sheet to ensure monetary reduction.

Not only did Japan's central bank do almost the reverse of what the Fed has been doing, but they took too long to address their banking mess. They didn't fix their banks until 2002/2003. Their dilly-dallying through the 90s allowed zombie banks with huge non-performing loans to operate. This placed a heavy burden on the Japanese economy.

In contrast, the U.S. moved with breakneck speed to fix its banks – remember the 'stress tests' and TARP funds. Banks were encouraged to write-down their assets and assisted to recapitalize their balance sheets. A very steep yield curve, a direct result of the Fed's aggressive actions, is helping the healing process along.

While issues no doubt still remain with U.S. banks, they are the polar opposites of the Japanese banking sector in the 1990s.

Sustainable Economic Growth

Deflation in the U.S. remains a risk, but the Fed's aggressive actions significantly lower the odds. The discussion above shows that while the two economies faced similar shocks (real estate bubble bursts), the U.S. policy makers are benefiting from the missteps that caused and entrenched the Japanese deflationary spiral. The only scenario where the odds of deflation actually increase is if the U.S. economy goes into a double-dip recession. And it is considered that a very unlikely scenario.

The economy's growth momentum has slowed. But this is more in the nature of a transitory pause than a new downturn. Estimates for the third and fourth-quarter GDP growth rates have been coming down in recent days, but remain in the 2% to 2.5% range. This gives the economy enough momentum to push above-trend growth levels again next year.

While household de-leveraging remains a weak spot, specifically given the protracted labor market softness, the corporate sector is in excellent shape. This was unmistakably borne out by the solid second-quarter earnings reports and managements' earnings outlooks for the rest of this year and next. A very profitable corporate sector, flush with cash and beginning to loosen its purse strings for capital investments, remains the economy's core growth asset. With the labor market continuing to mend, albeit at a slower-than-expected pace, the economy's growth momentum will further widen.

With Germany recently reporting its greatest economic performance in years and the Chinese authorities expected to ensure a gentle landing, the international growth outlook remains supportive for the U.S. recovery as well.

What Does It Mean For Your Stock Portfolio?

If the economy is on course to avoid a Japan-like scenario and remain on a growth path, then what do we make of all those investment dollars going into bond funds referred to earlier?

It is expected that those investors to be in for a shock in the coming months and quarters. While treasury yields may go down some more due to continuing fears about the macro picture, the overall trend is clearly upwards. Treasury yields are bound to rise from the current historical low levels. And as this trend comes into play, bond investors will be facing significant capital losses.

Most individual investors get bond-market exposure through mutual funds. Take a good look at such holdings and cash in the gains while the going is still good. You can replicate any investment strategy and style in the stock market. The coming bond bust will let loose a torrent of new money in the stock market; get ready for that ahead of time.

There are those that have never been a big fan of passively owning broad stock market indexes through mutual funds. It is believed in conscious and deliberate stock picks, using a regimented investment framework. Stocks of companies that offer compelling products and services, enjoy above-average earnings prospects, and trade at reasonable multiples offer the best bet to generating stock market-topping returns.