Q&A: Bond Performance and Valuation Concerns

In my continuing Friday Q&A series, I answer questions that RealMoney subscribers have emailed me on any subject. I'm going to do the same open-forum format next week, too, so whatever question you have, whether it's on specific stocks, the market in general or on accounting or corporate-governance issues, email it to me and I'll try to answer it.

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Question: I have been surprised by the poor performance of high-yield bonds and high-yield bond funds in the past month. I thought that high-yield bonds performed pretty well during a recovery, as some of their risk premium is removed as companies begin to experience improving market conditions. Obviously I was wrong. What are your thoughts on this?

-- D.M.

Answer: The entire fixed-income market is reeling lately, including both Treasury bonds and junk bonds, with a breathtaking fall in the 10-year bond beginning in June. When rates go up, bonds go down, regardless if they're junk or not. However, I still think they're overvalued, especially when compared with the average equity. The average publicly traded company generates a free cash-flow yield of more than 4%. There's no reason to prefer a 10-year bond yield of roughly 4.5%, fully taxable, against the income generated by the average stock, unless you're a staunch bear on the economy.

When I critiqued Bill Gross' prediction for Dow 5000 last September, I mentioned the "irony" in his analysis: that it wasn't the equity market that was overvalued, but the bond market. After a 20-year bond run, "a rally without parallel in the last 100 years," my position remains the same. Expect a problematic bond market for the remainder of the decade, at least.

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Question: Can you please explain why Applied Materials (AMAT - commentary - Cramer's Take) and KLA-Tencor (KLAC - commentary - Cramer's Take) are so overvalued? Earnings are not that great, so why are they at such a high price?

-- A.R.

Answer: Investors in Applied Materials and KLA-Tencor are living in the past. I'm very comfortable staking out the position that technology is yesterday's story. The Nasdaq's current rally is nothing more than a significant cyclical rally in a long-term bear market. The fundamentals support that position: The businesses at Applied Materials and KLA-Tencor are simply not worth $31 billion and $10 billion, respectively. The risk of holding these companies is outsized, and the potential return is meager. Paint the most optimistic scenario and compare it with the business valuations. You'll come to the same conclusion as I have: There's hardly enough reward to justify the risk.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, Alsin and/or ACM was long Warnaco and Tupperware, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.