shrinking bond yields ii

why look at bonds? 

If we’re stock market investors, why are we interested in bonds anyway?  It’s because at bottom we’re not really interested in stocks per se.  We’re interested in liquid publicly-traded securities–i.e., stocks, bonds and cash.  We’re interested in publicly-traded securities because we can almost always sell them in an instant, and because there’s usually enough information available about them that we can make an educated decision.

 

comparing bonds with stocks

bond yields, at yesterday’s close

One-month Treasury bills = 2.18%

Ten-year Treasury notes = 2.07%

30-year Treasury bonds = 2.57%.

S&P 500

Current dividend yield on the index = 1.7%.

 

According to Yardeni Research (a reputable firm, but one I chose because it was the first name up in my Google search), index earnings for calendar year 2019 are estimated to be about $166, earning for the coming 12 months, about $176.

Based on this, the S&P at 3000 means a PE ratio of 18.0 for calendar year 2019, and 17.0 for the 12 months ending June 2020.

Inverting those figures, we obtain an “earnings yield,” a number we can use to compare with bond yields–the main difference being that we get bond interest payments in our pockets while our notional share of company managers remains with them.

The 2019 figure earnings yield for the S&P is 5.6%; for the forward 12 months, it’s 5.8%.

the result

During my time in the stock market, there has typically been a relatively stable relationship between the earnings yield and 10-/30-year Treasury yields.  (The notable exception was the period just before the 2008-09 recession, when, as I see it, reported financials massively misstated the profitability of banks around the world.  So although there was a big mismatch between bond and stock yields, faulty SEC filings made this invisible.)

At present, the earnings yield is more than double the government bond yield.  This is very unusual.  Perhaps more significant, the yield on the 10-year Treasury is barely above the dividend yield on stocks, a level that, in my experience, is breached only at market bottoms.

Despite the apparently large overvaluation of bonds vs. stocks, there continues to be a steady outflow from US stock mutual funds and into bond funds.

the valuation gap

Using earnings yield vs coupon rationale outlined above, stocks are way cheaper than bonds.  How can this be?

–for years, part of world central banks’ efforts to repair the damage done by the financial crisis has been to inject money into circulation by buying government bonds.  This has pushed up bond prices/pushed down yields.  Private investors have also been acting as arbitrageurs, selling the lowest-yielding bonds and buying the highest (in this case meaning Treasuries).  This process compresses yields and lowers them overall.

–large numbers of retiring Baby Boomers are reallocating portfolios away from           stocks

–I presume, but don’t know enough about the inner workings of the bond market to be sure, that a significant number of bond professionals are shorting Treasuries and buying riskier, less liquid corporate bonds with the proceeds.  This will one day end in tears (think:  Long Term Capital), but likely not in the near future.

currency

To the extent that 1 and 3 involve foreigners, who have to buy dollars to get into the game, their activity puts at least some upward pressure on the US currency.  The dollar has risen by about 2.4% over the past year on a trade-weighted basis, and by about 3% against the yen and the euro.  That’s not much.  In fact, I was surprised when calculating these figures how little the dollar has appreciated, given the outcry from the administration and its pressure on the Fed to weaken the dollar by lowering the overnight money rate. (My guess is that our withdrawing from the TPP, tariff wars, and the tarnishing of our image as a democracy have, especially in the Pacific, done much more to damage demand for US goods than the currency.)

high-yielding stocks as a substitute for bonds?

I haven’t done any work, so I really don’t know.  I do know a number of fellow investors who have been following this idea for more than five years.  So my guess is that there aren’t many undiscovered bargains in this area.

 

my bottom line

I’m less concerned now about the message low bond yields are sending than I was before I started to write these posts.  I still think the valuation mismatch between stocks and bonds will eventually be a problem for both markets.  But my guess is that normalization, if that’s the right word, won’t start until the EU begins to repair the serious fissures in its structure.  Maybe this is a worry for 2020, maybe not even then.

It seems to me that the US stock market’s main economic concern remains the damage from Mr. Trump’s misguided effort to resuscitate WWII-era industries in the US.  The best defense will likely be cloud-oriented cash-generating software-based US multinationals.  (see the comments by a former colleague attached to yesterday’s post).

 

 

 

 

 

the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

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

Indexology

‘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.