“If there is an argument to be made for a potentially waning bull market, or even a “bubble”, it’s in bonds, not stocks.”
Each new year brings a natural inclination to review of the previous year’s investment markets, and this today is no exception. Not surprisingly, there are a lot of commentaries and reviews suggesting that the long run-up in stocks must be coming to a close – with not a few warning that the bull market is approaching “bubble” status. We respectfully disagree with that assessment of equities, and in past commentaries, we’ve given our reasons for belief in continued strong equity performance. We say that even in light of the 2,200 point sell-off on the Dow as of this writing.
In this blog post, we want to take a different – perhaps radically different – perspective and focus on bonds. If there is an argument to be made for a potentially waning bull market, or even a “bubble”, it’s in bonds, not stocks.
By any reasonable definition, bonds have been in a bull market for the past thirty plus years. That doesn’t mean bonds have risen every month, quarter, or even year, but it does mean that bond returns have been very good ever since the late 1970s. When the Fed ended inflation in the ‘70s, bond yields began a consistent drop which still today leaves us with historically low interest rates. As those bond yields have fallen, bond values have risen. The trade-off between lower interest payments on bonds and rising values has delivered good positive total returns for bonds over the last 30+ years.
The current 10-year Treasury yield is in the 2.45% range. If translate this into the language usually used for stocks, it means the PE ratio for 10-year treasuries is roughly 40. I think most readers would be very concerned if a salesperson approached them and recommended investing in a stock with a 40+ PE ratio. We all know enough to be concerned about such high PEs. Yet somehow, we don’t use the same logic for bond investments that we do for stock investments. Therein lies the danger.
For those who aren’t worried about bonds, there are typically two main arguments – one technical, the other “strategic”.
The Technical – Foreign yields are lower than U.S. yields, so market arbitrage will keep U.S. yields from rising.
The “Strategic” – The U.S. faces secular stagnation – permanently low growth and low inflation, so there’s no pressure for interest rates to rise.
There are serious problems with each of these arguments, and they can be de-bunked fairly easily.
The Technical: The theory that bond yields in one country dictate yields in another country just doesn’t hold up. The clearest example comes from Japan. Japanese bond yields have been near zero for at least 20+ years. If international arbitrage really works to bring all rates together, why aren’t U.S. bond rates near zero, or why didn’t Japanese bonds move higher to the US level? And that just compares two countries. The theory really falls apart when you start looking at all the interest rates around the world.
The truth is that bond yields are determined by the fundamentals in each country. Every country has different growth rates, currencies, inflation, trade flows, credit ratings, tax rates, and banking rules. In short, every country is unique. Why would we expect bond yields to be the same?
The Strategic: Secular stagnation was a watchword first created in the early ‘70s. President Carter used the term to explain the economy which wouldn’t move out of the doldrums. The ‘80s proved how wrong this was. To the extent that bonds are supposed to predict the future, this experience in the ‘70s and ‘80s proved how wrong that is.
In 1972, the 10-year U.S. Treasury yield averaged 6.2%, predicting moderate inflation and good growth. The truth, as President Carter and the rest of us experienced, was high inflation and low growth in the decade which followed. In 1981, the U.S. Treasury yield averaged 13.9%, which according to the theory predicted high inflation and low growth. Again, the truth was the opposite – the ‘80s gave us low inflation and strong growth.
In each historical case, this interest theory predicted the wrong outcome; the bond market underestimated inflation in the 1970s and then severely overestimated it in the 1980s.
The main reason the theory falls apart is because it is based on human emotions, not economic principles. People – and all investors are people – tend to take their current or recent experience and project it into the future forever. It’s a natural human tendency; we can all fall captive to our emotions and immediate experiences. But truth is not dictated by what we’re feeling or experiencing at the moment. Truth is dictated by what actions are actually taken – by governments, by currency boards, and by companies and employees who decide whether to invest or whether to sit on the sidelines.
So, our low-interest rates and our recent plow horse economy do not accurately predict a specific future. Interest rates are influenced by Fed action, and economic growth is influenced by perceptions of government tax and regulatory policy. What was true as recent as mid-2017 may not now be true. In fact, we are seeing dramatic changes in perception at the Fed and among consumers and investors. Today, there is optimism, increased investment activity and job-seeking, and rising projections of current and future GDP growth.
With real GDP growth picking up to roughly 3%, and inflation moving toward 2.5%, or higher, nominal GDP will grow at roughly a 5.5% rate. That’s the fastest top-line growth the U.S. has experienced since 2006. The economy is picking up speed and should do very well.
The only foreseeable problem would be a trade war. While there is talk of that from the current occupant of 1600 Pennsylvania Ave., we don’t see Congress going along with such a disastrous strategy. Yes, it’s possible, but it is highly unlikely. Instead, we see economic growth AND rising interest rates – at least to more “normal” historical ranges. This portends well for stocks and less so for bonds. Interest rates will rise and bond values will come under pressure. That 40 PE ratio will be tough to maintain.
So, what to do with our observations and predictions? Sell bonds, invest heavily in stocks???? Regular readers of our blog know differently. We cannot predict the near-term direction of stock prices, bond yields, or bond returns. Furthermore, beyond the “total return” earned by each asset class, there is the ever-important volatility (or risk) factor. We recommend portfolio structures for our clients which invariably include both stocks and bonds in order to control and minimize risk across the economic and market cycle. Even when one investment category (broad stocks or broad bonds) seems to be out of favor, we recommend a disciplined long-term commitment to an allocation which will over the long-term accomplish the investor’s goals. We don’t change that based on near-term projections of who’s on top and who’s on bottom, because the truth is that nobody is really good at predicting which investment category will be on top, and which will be on the bottom.
We do not recommend timing the market or timing the categories. Are bond returns going to struggle? Yes, they are. Should you leave bonds and jump into stocks? No, because we cannot predict when the situation will reverse, or when both bonds and stocks might struggle. Furthermore, we know that bonds and stocks together mitigate risk. No one portfolio of just bonds, or just stocks, will perform as well over time as one with a mix of both bonds and stocks.
What we know with confidence is that well-balanced portfolios, tethered to an established goal and target, will over the long-haul produce wealth and security unavailable to by other approach. And we write that even in light of the current 8.5% drop in the Dow.