Bond Versus Equity Smackdown

Investors are deeply divided about the strength and viability of the economic recovery—and whether the environment favors stocks or bonds.

Some believe that the economy will continue to grow. As it gains traction, inflation will become more of an issue, and interest rates will rise in an effort to keep it under control. That will undercut the value of fixed-income investments and boost the value of stocks. Others believe that weak growth and an anemic jobs market will remain a problem for years, depressing earnings and keeping a lid on inflation and interest rates.

Hedge funds and investment companies are forming macro views of the economic future and placing huge bets accordingly. This is how a few well-known portfolio managers view the economy and the markets:

On Monday, hedge fund manager John Paulson, known for making billions by betting against subprime mortgages at the top of the housing bubble, told investors that he has turned bullish on equities, according to Zero Hedge, which posted notes of the meeting. "Paulson’s case for equities in general focused on the discrepancy between equity earnings yields of about 7 percent to 8 percent now compared to the 10-year yield at 3.6 percent. This is one of the highest dislocations since they started tracking these numbers," Zero Hedge says.

Paulson also reportedly told the group it is the best time in 50 years to buy a home because prices will rise as the economy revives. Meanwhile, interest rates will go back up, possibly into the low single digits by 2012, Paulson reportedly said. That would be a boon for people who locked in mortgages at low rates. He said bond prices will fall and yields will rise as the Treasury continues to issue more debt to sustain economic stimulus. He argues that gold will continue to rise as a hedge against inflation.

In a similar vein, Ken Fisher, CEO of Fisher Investments, said at an investment conference in Sydney that "we've got a great future." He described visions of a "new normal" of slow growth and U.S. decline as "idiotic."

According to Bloomberg, Fisher, who manages $35 billion, said "we are chimpanzees with no memory. The next 10 years are going to be just as good as the 1990s. The problems in this current environment we think are so different, and so new and so unique—it’s the same stupid old normal we’ve always had.”

Fisher was responding to comments from PIMCO leaders Bill Gross and Mohamed El-Erian. The leaders of the largest fixed-income shop are reportedly in line to succeed outgoing Obama economic adviser Larry Summers. Gross said today in a note on his website that “future investment returns will be far lower than historical averages. If bond investors believe that the resplendent and abundant capital gains of the past 25 years will be duplicated from yield levels of 2 to 3 percent—well, they just haven’t been to Japan, have they?”

His investment outlook favors bonds, but not by much:

"Investors are faced with 2.5 percent yielding bonds and stocks staring straight into new normal real growth rates of 2 percent or less. There is no 8 percent there for pension funds. There are no stocks for the long run at 12 percent returns."