bonds …a threat to stocks?

I read an odd article in the Wall Street Journal yesterday, an opinion piece that in the US bonds are a current threat to stocks.  Although not explicitly stated, the idea seems to be that the US is in the grip of cult-like devotion to stocks.  One day, however, after a series of Fed monetary policy tightening steps, the blinders we’re wearing will drop off.  We’ll suddenly see that higher yields have made bonds an attractive alternative to equities   …and there’ll be a severe correction in the stock market as we all reallocate our portfolios.

What I find odd about this picture:

–the dividend yield on the S&P 500 is just about 2%, which compares with the yield of 2.3% on a 10-year Treasury bond.  So Treasuries aren’t significantly more attractive than stocks today, especially since we know that rates are headed up–meaning bond prices are headed down.  Actually, bonds have been seriously overvalued against stocks for years, although they are less so today than in years past

–from 2009 onward, individual investors have steadily reallocated away from stocks to the perceived safety of bonds, thereby missing out on the bull market in stocks.  If anything there’s cult-like devotion to bonds, not stocks

–past periods of Fed interest rate hikes have been marked by falling bond prices and stock prices moving sideways.  So stocks have been the better bet while rates are moving upward.  Maybe this time will be different, but those last five words are among the scariest an investor can utter.


Still, there’s the kernel of an important idea in the article.

At some point, through some combination of stock market rises and bond market falls, bonds will no longer be heavily overvalued vs. stocks and become serious competition for investor savings.

Where is that point?  What is the yield level where holders of stocks will seriously consider reallocating to bonds?

I’m not sure.

Two thoughts, though:

–I think the typical total return on holding stocks will continue be around 8% annually.  For me, the return on bonds has got to be at least 4% before they have any appeal.  So the Fed has a lot of interest-rate boosting work to do before I’d feel any urge to reallocate

–movement in yield for the 10-year Treasury from 2.3% to 4.0% means that the price of today’s bonds will go down.  So, while there is a clear argument for holding cash during a period of interest rate hikes, I don’t see any for holding bonds–and particularly none for holding bonds on the idea that stocks might fall in price as rates rise

Of course, I’m an inveterate holder of stocks.  And this is an interesting question to ask yourself.  What yield on bonds would make them attractive to you?



actively managed bond funds in a rising interest rate environment

During my working career as an equity portfolio manager, I experienced the US bear markets of 1980-82, 1987, 1990-91 and 2000-2002. Because I spent the majority of my career as a global manager, I also lived through the collapse of the Japanese stock market (then by far the largest in the world) in 1989 and the currency-triggered bear market in many smaller Asian countries in the late 1990s. I started writing this blog as a way of helping myself think about the bear market of 2007-09 and what would follow.

In other words, for equity managers there have been lots of bad times to help us along with the painful process of being able to, as they say, make the critical distinction between brains and a bull market.

Also, the bad periods themselves have been long enough to force us to recognize that different investment styles (growth or value) work best in different economic circumstances.  We certainly won’t change our overall philosophies.  However, successful equity managers all realize that for them there are some times to be in fifth gear with the gas pedal to the floor and others to be in second gear and tapping on the brakes.


Looking at the bond world from the outside, it seems to me that little of this has been the case for bonds and bond managers since the early 1980s.  Yes, junk bonds or emerging markets debt may have gotten ugly now and again.  Nevertheless, the continual decline in interest rates from the early Volcker years to the present has made for a remarkably smooth, and consistently bullish, ride for bond investors and managers.

The amazing part is not a long bullish period–after all, equities in the US had that for most of the 1990s–but the fact that the benign environment lasted over thirty years.  To have experienced an ugly time for bonds comparable to what happens to stocks every business cycle, you would have to have been a bond manager in the 1970s!

This is my main concern for actively managed bond funds.

We’re (already) in a period in which interest rates are not going to decline.  They may fluctuate for a while, even a long while, but the new main trend is going to be for rates to rise.  And we haven’t had circumstances that have forced bond managers to cope with a situation like this for decades.

Instead, the recipe for success over the past thirty-five years has been to throw caution to the winds and bet as heavily as possible on continuously declining rates.  The most successful managers would have been the most aggressive, the ones willing to double down on any bet gone wrong and to stack their portfolios full of risk.  Brash, bold, stubborn, no sense of nuance, not the brightest crayon but tenacious.  Think Jon Corzine and what happened to him.


Will bond fund managers be able to adjust to the changing trend?  I don’t know.

Bill Gross is another interesting case in point.  He became the “bond king” by betting aggressively on lower interest rates.  My reading of his results for his last several years at Pimco is that he tried to keep his performance numbers up by layering on extra amounts of risk to the main bet that had stopped providing results.  That didn’t work so well, in my view.  Since leaving for Janus, where he could express his ideas in his portfolio without an outside sanity check (outside interference?), he’s done poorly.

This is not about old dogs and new tricks in the sense of age but only in having the temperament and mental flexibility to adjust to changing circumstances.


want index underperformance …try an actively managed bond fund


‘For a while I’ve been following the Indexology blog written by S&P.

As the name and source suggest, the blog extolls the virtues of indexing–after all, S&P makes them and sells information about them.  I find the posts to be generally interesting.  My only quibble is that the Indexology people seem to be true believers in a strong version of the efficient markets hypothesis.  They’ve all drunk the Kool-aid and don’t stop to question how it can be that basically every professional active manager underperforms   …nor do they try to imagine what circumstances could create even a temporary burst of outperformance.

I’m well aware of all the figures about equity manager underperformance.  However, I’d never thought much about bond funds, the subject of the Indexology post of March 12th.

The numbers are stunning.

bond fund (under)performance vs. benchmarks

Here they are:

–in 2014, 97% of the government bond funds underperformed, as did 98% of the investment-grade corporate bond funds

–in both categories, over 95% underperformed over the past five- and ten-year periods

73% of the junk bond fund managers underperformed in 2014; over the past five years, 88% underperformed; over the past ten, the number is 92%.

Bright spots?:

–among actively managed senior loan funds (which don’t contain bonds;  they hold pieces of syndicated bank loans to non-investment grade corporate borrowers), 70% outperformed last year.  Over the past decade, though, underperformers and outperformers are just about equal in number.

–61% of municipal bond managers outperformed in 2014.  55% did so over the past fie years.  However, over the past ten, 70% underperformed.

reasons for this woeful showing?

Indexology offers none.  Personally, I have no firm ideas.

Looking only casually at the results of Bill Gross over his years at Pimco left me with two impressions of the former Bond King:

— he continually bet very aggressively (and correctly) that interest rates would fall–sort of like an intelligent version of Jon Corzine, and

–a large chunk of his outperformance disappeared through the high fees Pimco charged for his services.

Indexology doesn’t talk about fees, which can’t have improved the situation for bond managers generally–and I presume the Indexoogy numbers are after them.

The better areas for relative performance are smaller and contain less liquid securities.  I wonder what role pricing–which I presume is not based on daily trading but on the theoretical models of third-party experts–plays?


Shaping a portfolio for 2014 (iv): interest rates

the current situation in the US

The first time I visited Taiwan, in 1985, I was struck by the presence of armed soldiers–bayoneted rifles at the ready–at the toll booths on the highways.  It turned out Taiwan had been in an official state of emergency, guarding against possible invasion from the mainland, for a very long time.  The reality of the 1980s, however, was that the Peoples Liberation Army didn’t have enough boats to launch an invasion.  Also, what trucks they had would have broken down on the way to the ports, leaving would-be invaders scattered in small groups around the countryside and forced to hitchhike back to their bases.

Monetary policy in the US is a lot like the Taiwanese state of emergency–except that the Fed, through Quantitative Easing, continues to issue its metaphorical soldiers ever-longer bayonets and more bullets.

It wants to stop doing that, by “tapering,” or decreasing the rate at which it pumps extra amounts of money into the US economy.  It doesn’t want to roll back the state of emergency–by raising short-term interest rates from the current zero to a “normal” 4% or so–for at least two years.  The process of normalization itself will presumably take several years to complete.

economic consequences

The current situation is great for anyone who wants to borrow money.  It’s horrible for savers (read: senior citizens).

The Fed is not maintaining its state of emergency because it thinks the economy is too weak to tolerate higher rates.  Rather, its “dual mandate” from Congress legally binds it to try to fight the current high level of unemployment, a task that normally falls to fiscal policy from the administration and Congress.

The failure of fiscal policy–normally public works construction + worker retraining–means that financial incentives are skewed in a potentially harmful way.  Also, the Fed has nothing left in the tank to respond to any new emergency that may arise before rates are back up to normal.  We’d have to depend on the administration and Congress.  But that’s the world we live in.

investment implications

Two opposing forces:

–the Fed has no intention of raising rates for a long while, but

–raising, earlier this year, the possibility of starting to slowly wean the economy from ever-accelerating expansion of the money supply signaled that the thirty-some year era of continually looser money policy–with its accompanying ever-lower interest rates, ever-higher bond prices–is over.  The next move, when it comes, is a reversal of form.  Higher rates, lower bonds.

My take:

–in past times of post-crisis rate normalization, bonds have gone down, stocks have gone sideways to up

–historically, a turn in the price of any commodity comes in two phases.  The first is anticipatory, as the market perceives a change is likely.  That’s followed by a volatile sideways movement, which ends when the commodity begins to rise in price.  That’s my best guess of what will happen with interest rates and bond prices–trendless volatility.

–the present crop of professional traders don’t strike me as being particularly astute students of history.  Few will have actually experienced during their professional careers an extended period of Fed tightening.  No one has seen a Fed tightening of the peculiar type we will be undergoing in coming years.

We’ve already seen the anticipatory move in bond prices.  The Fed thought it was irrational enough that it spent months unruffling traders’ feathers.  It’s possible that next year the trading community will make the ride bumpier than it needs to be.

A world awash in money?: the Bain view

The other day I was reading a column in the Financial Times that referred to a study by the consulting company Bain.  Published late last year (I missed it then), it’s called A World Awash in Money.

Its basic premise is that the present condition of a “superabundance” of investment capital looking for a place to go to work is a permanent feature of the financial landscape.  Therefore, asset prices will remain higher than the consensus expects; interest rates will remain lower.

Three factors are involved:

–financial innovation, high-speed computing and increased use of leverage have allowed the pool of investment capital in the advanced economies to expand at a very rapid rate over the past couple of decades

–during the same time, GDP in the US and EU has been growing slowly, providing fewer new investment opportunities, and

–emerging economies like China will soon turn from being capital users to capital exporters, significantly increasing the amount of global capital searching for high-return projects to invest in.

In Bain’s view, this situation will have a number of important consequences:

1.  interest rates will remain (much) lower than the consensus expects

2.  in a capital-glutted world, bubbles like those in 1999-2000 and 2006-2007 have a high chance of recurring.  Therefore, investors must be ready to anticipate them and take defensive action

3.  investors will be forced to consider projects with extremely long duration (think: 20 or 30 years) to achieve superior returns

4.  the risks of investing in the developing world, where capital will be needed the most, will become more palatable to return-starved global investors

5.  achieving substantial real returns will require that both portfolio investors and company treasurers abandon their buy-and-hold, long-only mindset and become more like hedge funds.


I always find studies like this one interesting.  It’s not necessarily because they turn out to be correct.  It’s that they force you to think about the “big picture” and form an opinion on important investment issues.  In this case, it’s what happens if interest rates stay low.

I also find studies that argue, in effect, that the current state of the economic/financial world will persist for a long time to be particularly worrying.  In my experience, most times they come just before some dramatic and unanticipated change.

My take on the Bain study tomorrow.

stock prices in a rising interest rate world (II)

why should stock prices decline if bond prices do?

The main argument that they should is an economic one–that demand for stocks (or bonds, for that matter) is only one expression of a more basic demand, a desire for savings.  That demand expresses itself in interest in liquid vehicles like stocks, bonds, or cash, as well as illiquid ones like real estate or hedge funds.

Allocation among investment vehicles is partly a function of individual preferences, partly one of price/expected return.  In theory, investors change their allocation among liquid alternatives like stocks, bonds and cash depending, at least to some degree, on their perception of relative value.  So, if bond prices go down (bonds become cheaper), investors will allocate more new money to bonds and will sell some of their (now relatively more expensive) stocks to buy bonds.  Professional arbitrageurs may join in, too.  This selling makes stocks go down, too.

In the real world, however, this doesn’t always happen.

Look at recent history.  Stocks are up 150% over the last four years, while individuals have shunned equities and poured money into bonds.  No judgment of relative value there.  No consideration of potential future returns.

What about the AAPL bond offering?  Only a few weeks ago, people were more than happy to buy AAPL 30-year bonds with a(n ultra-low) coupon of 3.85%, even though the Fed had been making it clear for a long time that the normal rate on cash should be higher than that.  No long-term thinking here.  Those bonds are now more than 10% lower, as sentiment has changed.

end of recession vs. end of the business cycle

When the economy is overheating and chronic inflation threatens (not the situation we’re in now), the Fed raises rates.  Bond prices drop.  Anticipating lower profits, stocks also fall.

At the end of recession, on the other hand, the Fed raises rates from emergency lows back to what it judges to be normal (inflation + a real return for lenders).  Bond prices fall.  Historically, in this situation stock prices don’t.  Historically, they go sideways to up, because the Fed’s intention is to remove emergency assistance, not to slow profit growth.

It seems to me that this is a key difference that Wall Street is overlooking so far.  I can understand why the bond market is upset, though.  I would be too if I thought that thirty years on cruise control, riding the gravy train of ever-lower interest rates, is over.

does the absolute level of interest rates matter?

Jim Paulsen’s comments that I wrote about yesterday made me think back to a simpler time–the mid-1980s.  Arguably, you have to go back that far to get a period when markets weren’t distorted by Alan Greenspan’s penchant for very loose money policy.

Back then, it seemed to me that investors looked carefully at the return they could get on a cash deposit vs. what the stock market might offer.  If money markets began to yield, say, 5%, some market participants would begin to shift money out of stocks and into cash.  The idea seemed to be that a 5%, 0r a 6%, return that was very likely over the following twelve months and that involved very little risk was preferable to a potential 8%-10% return that required taking the risk of owning stocks.

I don’t know, but it may be that the absolute yield on cash will be a more important consideration again today for stocks than their relative value vs bonds.  If so, in today’s world, a 4% yield on cash might be the threshold for switching out of stocks.  Maybe it’s 3.5%.  But it’s certainly not the current zero.

stock prices in a rising interest rate world (I)

Jim Paulsen

I’ve been a fan of Jim Paulsen of Wells Capital Management (part of Wells Fargo) for a while.  My only caution is that his thoughts and mine usually run along the same optimistic lines.  So he provides me more confirmation of my own views than a radically different viewpoint to test them against.

stocks should be okay

His latest Economic and Market Update, dated June 25th, talks about what happens to stocks when interest rates begin to rise after a recession.  He focuses on consumer confidence as the key variable to watch.  So far it’s signaling that stocks should be okay even as interest rates rise (and bond prices fall).

my thoughts

Up until now, I’ve been mostly satisfied with the argument that over the past thirty years stocks have always gone sideways to up as the Fed raises rates from recession-induced emergency lows.  Recently, though, I’ve been trying to think through what might go wrong this time.  All I can come up with is:

–the Baby Boom is older and has different investment preferences

–the road back to normal rates is an especially long one (in keeping with the severity of the Great Recession)

–market participants seem to me to be less thoughtful and more emotional (maybe the result of using cable tv as an information source).

None of these is enough to change my mind that stocks will be basically okay.  But I’ve also been looking for positive arguments that reach this conclusion–not just lack of strong reasons to be suspicious of past investor behavior in similar circumstances.

one key distinction to make…

…before we go any farther.

What we’re talking about is Fed action that brings money policy from accommodative (loose) to normal, not normal to restrictive (tight).  The difference?

–the Fed fights recession by setting short-term interest rates below the rate of inflation.  In other words, it more or less gives the money away to anyone who promises to spend it!!  It does this to simulate investment and consumption.  Ending the giveaway by moving rates back up to slightly above inflation and giving lenders a real return on their funds, is the move from loose to normal.

–on the other hand, when the economy is expanding too quickly and creating inflation, the Fed moves rates substantially higher than inflation.  Its intention is to slow economic activity back down to a sustainable rate.  That’s not what the Fed is doing now.  (In fact, it’s not even talking about stopping the giveaway.  It’s only suggesting it may slow down the rate at which it shovels the money out the door.

Paulsen’s observation

Paulsen’s main point in his June 25th strategy piece is that during periods when interest rates are rising, there’s a strong positive link between consumer confidence and stock market performance.  Historically, the S&P has advanced on average at a 12.8% annual rate during months when bond prices were falling but consumer confidence was rising.  However, when bonds were falling and confidence was dropping as well, the S&P also declined, at a 6.4% annual rate.

Paulsen cites two consumer confidence measures, the monthly Consumer Confidence Present Situation Index from the Conference Board, which has been advancing steadily since late 2011, and the daily Rasmumssen Consumer Confidence Index, which has also been rising since August 2012.  Both indices have continued to go up, despite the recent rise in Treasury bond yields.

In his strategy update, Paulsen is a little vague about what he thinks is in store for stocks.  He says, “Yes, yields are rising.  But the key is that improving confidence seems to be at the core of what is driving them higher.  If this continues, higher interest rates should not materially impact economic activity and the stock market may continue to provide favorable results.”

In a slightly earlier (June 18th) piece, Dr. Paulsen is more specific.  There, he says his guess is the S&P will move in a 1550 – 1750 range through yearend, before beginning to advance higher in 2014.

That’s providing consumer confidence continues to be strong.

More tomorrow.