The classic MLP pays out high distributions backed by unbreakable long-term contracts with major energy firms.

— Elliott Gue, MLP Profits

Even bond king Bill Gross gets its wrong sometimes. Back on March 3^rd, I wrote how the PIMCO chief was recommending that investors sell long-term U.S. Treasuries in anticipation of the end of QE2 at the end of June. Gross predicted that yields would increase (i.e., bond prices would decrease) because without the Fed as a buyer bond supply would exceed private demand. As it turned out, the exact opposite occurred with prices of long-term U.S. Treasuries skyrocketing, outperforming the S&P 500 by more than 37 percentage points:

Bill Gross entitled his October market commentary “Mea Culpa” and apologized for being so very wrong and causing his bond fund to underperform its BarCap U.S. Aggregate Index’s benchmark 1.06% versus 3.99% year-to-date:

This year is a stinker. PIMCO’s center fielder has lost a few fly balls in the sun. The simplest explanation involves the global flight to quality triggered by the European debt crisis and the politically-induced deterioration in this country’s growth outlook. As a result, “consensus” expectations did much more than converge to PIMCO’s “New Normal” scenario; they went right through it. The portfolio at midyear was positioned for what we call a “New Normal” developed world economy – 2% real growth and 2% inflation. When growth estimates quickly changed it was obvious that I had misjudged the fly ball: error centerfield.

So where do we go from here? Our internal growth forecast for developed economies is now 0% over the coming several quarters and the portfolio more accurately reflects this posture.

In a related market commentary, he sounds even more pessimistic:

There are no double-digit investment returns anywhere in sight for owners of financial assets. Bonds, stocks and real estate are in fact overvalued because of near zero percent interest rates and a developed world growth rate closer to 0 than the 3–4% historical norms. There is only a New Normal economy at best and a global recession at worst to look forward to in future years.

Where’s my Prozac? How depressing. Gross is so sure that the U.S. faces zero economic growth or recession that he has completely flipped-flopped on bond maturities, more than doubling the effective duration of PIMCO’s flagship Total Return Fund from 3.5 to 7.1. Effective duration is a measure of how sensitive a bond portfolio is to rising interest rates. A 7.1 effective duration means that the bond portfolio will lose 7.1% for every 1% rise in long-term U.S. Treasury interest rates.   

Jeffrey Gundlach: The Second Bond King

As with medical diagnoses, I look for second opinions regarding economic diagnoses as well. Enter superstar bond investor Jeffrey Gundlach of DoubleLine Capital, who says that the U.S. is already in recession. In a recent CNBC interview, he pointed out that the mortgage-backed securities (MBS) market – both subprime and prime — has not only failed to participate in the recent stock market rally, but has been in a “quiet crash.”  Gundlach says that the U.S. economy cannot recover without the housing market recovering and the housing market remains “locked in a stable mood of ongoing defaults, and continued weakness in the recovery rates [of mortgage loans].”

In other words, the MBS market is pricing in a spike in mortgage-loan defaults, which is going to hurt the economy big time.

Implications of Weak Housing for the Stock Market

One big question is what any of this has to say about future stock-market returns. For example, is the weak MBS market a leading indicator of the stock market? If it is, then the stock market will soon follow the MBS market down to new lows. Housing is considered a leading economic indicator. It’s a component of the Economic Cycle Research Institute’s (ECRI) weekly leading index (WLI). Yet, at least one study finds no stable relationship between home prices and the stock market:

Evidence from the past 43 years indicates no contemporaneous relationship between the stock market and the residential real estate market. There may be a weak, inverse, multi-year relationship between home appreciation and stock returns.

Another question is whether widening yield spreads between corporate bonds and U.S. Treasuries means anything. There is no doubt that spreads have been increasing. For example, the spread between high-yield bonds and the 5-year U.S. Treasury recently hit 816 basis points (8.16 percentage points), more than double the spread justified by recent high-yield default rates. The junk bond market is clearly anticipating much higher bond defaults, which would signify a recession and a continued stock market decline.

Are Junk Bonds a Leading Indicator of Stocks?

Technical traders (i.e., chart readers) often allege that junk bond performance leads stock market performance. But I was skeptical and decided to compare the performance of a junk bond ETF (NYSE: JNK) with the Russell 2000 ETF (NYSE: IWM) between July 1^st and August 8^th. This is the time period when both bond and stock investors first started to fear a recession and began selling their holdings:

Source: Bloomberg

As you can see from the chart above, both junk bonds and small-cap stocks were hugging the 0% line up to July 22^nd. On July 23^rd, junk bonds remained unchanged but stocks started to fall first. In fact, a week later on July 30^th, junk bonds were still at the 0% line while stocks had already fallen by more than 5%.

Based on my little anecdotal example, as well as a 2009 academic study, I find no evidence that junk bonds lead stocks. If anything, stocks lead junk bonds.

Former finance professor Howard Simons recently concluded that there is no relationship between corporate bond spreads and future stock market returns:

For bond traders to insist their market sees the future of corporate cash flow and its risks before stock traders does beg the question as to why these very same bond traders then forgo the opportunity to use this advantage to close what would be a very open arbitrage. Kindness, I suppose.

The answer is simple: Stocks do not lead bonds and bonds do not lead stocks on any regular basis. Anecdotes exist; they always do. But those are your lying eyes talking, not your impartial calculations, and you are well-advised to ignore them.

Simons also argues that the widening spreads of corporate bonds over U.S. Treasuries is not worrisome because the widening is solely the result of U.S. Treasury yields declining and not corporate bond yields rising. Investors would demand higher corporate bond yields if they truly thought that corporate default risk was rising.

Bottom line: Although bond kings Bill Gross and Jeffery Gundlach are both bearish on the U.S. economy and junk bonds, no clear evidence exists that their bearish conclusions – even if proven correct – mean that stock prices will fall much farther from here. 

Michael Hasenstab: The Third Bond King

Want more good news? Look no further than the third bond king, Michael Hasenstab of Frankling Templeton, who said in late September that a new recession is “unlikely:”

If anything, most U.S. companies have underinvested in the last couple of years and that can be seen by the tremendous amount of cash on their balance sheets that they have not put to work. So there’s not a need for cleansing in either the investment or labor markets, and of course, the real estate markets have already had a huge correction. But, this is a recovery from post-financial market excess, so there is a lot of deleveraging. Typically, these types of recoveries are characterized by weaker-than-normal growth and also prolonged periods of higher unemployment. So, the conditions we are seeing today are not atypical, and they also don’t signal that we’re about to go into a major contraction.

Ride Out the Market Turmoil with Master Limited Partnerships (MLPs)

Even if both corporate bonds and stocks are heading down, master limited partnerships (MLPs) — which transport the stuff through pipelines — remain an attractive investment. The great thing about pipeline companies is that they get paid based on volume, not energy prices. MLPs have performed spectacularly over the past two years and yet are still not overvalued. As Roger Conrad of MLP Profits recently wrote:

Can anyone with a straight face call MLPs overvalued at an average yield plus 12-month dividend growth rate (i.e., projected annual return) greater than 8 percent?