Written by Ethan S. Braid, CFA on 5-23-2012
The last time I saw investors behave the way they are now, it was 1999. Back then the mere announcement of an analyst upgrade would send stocks like Red Hat, Ariba, and Commerce One skyrocketing as much as 20 points in one day. Forgotten Wall Street fortune tellers like Abby Cohen, Mary Meeker and Henry Blodget ruled the media. At that time 100s of billions of dollars poured into equity mutual funds, especially those funds who concentrated in technology. You couldn’t watch the T.V. for more than 10 minutes without seeing a Janus commercial touting their research abilities and outperformance capabilities.
Fast forward to today. The decade in the rear view mirror has given us:
- Two nasty bear markets for equities.
- A housing bubble.
- A financial collapse.
- Oil spiking to nearly $150/barrel (only to fall back down to approximately $60/barrel a few months later – which equated to a 60% drop for those who got emotional and acted on Goldman Sach’s $200/barrel prediction).
As a result of all of this fun, investors are anything but certain about the future. Now the name of the game is bonds and names like Bill Gross and Jeffrey Gundlach are the current playthings of the financial media...
What goes up comes down, the pendulum will swing, and trees never grow to the moon. Is there a striking similarity between 1999 and 2012? I believe so. Instead of 100s of billions of investor dollars chasing hot equity funds as they did in the late 1990s, the average investor is now chasing the last three decades of returns in the bond market...trend extrapolation, hindsight bias and herd mentality to say the least! According to Morningstar, for the years 2009 – 2011, open-end mutual fund taxable bond assets increased by $680 billion dollars, while at the same time, roughly $200 billion left U.S. stock funds. In fact, the total amount of assets in taxable bond funds has grown from approximately $1 trillion at the end of 2008 to the current level of $2.1 trillion (doubling in just three years). Yet while all of this investor money has poured into bond funds, the S&P 500 has returned nearly three times what the Barclays aggregate bond index has produced. Simply put, investors desire the perceived safety of bonds over the stock market. The volatility and lackluster returns of the equity market over the past decade have nullified investors’ appetite for risk. The great irony however, is that what is now perceived as safe (just like housing in 2004) may very well provide significant losses (and possibly worse than what the stock market did in 2002 and 2008) at some point in the not too distant future.
Predicting the direction of interest rates is a fool’s game, you are better off taking your money to Vegas. However, determining if there is a value in an investment and an opportunity to make money is an entirely different matter - something a skilled analyst is quite capable of deciding. With the 30 year treasury providing a scant 2.86% yield and inflation running at approximately 3%, how, can one make any real return on the long bond? If rates are stable, after adjusting for inflation, an investor is all but guaranteed to lose money. Throw in taxes on the 2.86% yield and the situation gets even worse. The only way this trade makes any sense is if the U.S. experiences deflation. Then, and only then, does this trade work. However, with the debt issues of the world upon us, inflation seems like a far more likely scenario than deflation, as governments search for a way out of their debt problems.
Going forward, there are three things that interest rates can do:
- Stay the same.
- Go up.
If you are bond investor today, you will lose in two of those three scenarios. Rising rates will bring sheer misery to most bond investors. Stable rates and stable inflation will equate to no real returns. Only declining rates can bring joy. If you are considering an investment and in two out of three scenarios you stand to lose, does that sound like a wise investment to you? Probably not, and yet money is pouring into bond funds as I type this memo.
Here is a wake-up call example to put things into perspective. If interest rates were to suddenly rise, how would the price of a 30 year treasury, trading at par ($1,000 per bond) with a 3% coupon be affected?
- Rates rise to 5% = new price for the bond of $690. 31% LOSS
- Rates rise to 6% = new price for the bond of $585. 42% LOSS
- Rates rise to 7% = new price for the bond of $501. 50% LOSS
Scared yet? As recently as Jun 2007 the 30 year treasury yield was 5.25%. From 1970 to the year 2000 the 30 year bond spent nearly all of those 30 years well north of 6%.
Now ask yourself, what value was available to investors in 1999 when dot.com stocks were selling for hundreds and sometimes thousands of times what a company’s earnings were (and that was for companies with earnings, many didn’t even have earnings)? Simple answer - none. We all remember how that story turned out too, by 2002 many of the internet darlings had delivered losses on the magnitude of 90%. At that time, many people learned a hard lesson about chasing yesterday’s winner and overpaying for an investment.
The current state of the bond market, investors’ desire to buy bonds at these yield levels, and the obvious lack of value provided by bonds is a clear signal to me that the end of the great bull market in bonds is near. I have no crystal ball to predict the future, but purchasing an investment that loses money in two out of three base cases is not a smart decision…and yet investors keep piling into bonds like there is no tomorrow.
Most likely we are setting the stage for excellent returns in the equity markets going forward. Many U.S. companies pay dividends in the 3 – 5% range, with multiples of book value beneath 2, responsible debt/equity ratios and multiples of cash flow in the 4 – 9 range. Compared to historical norms, equities are either at fair value or slightly undervalued. With the potential for share price appreciation, increasing dividends, and a global economy that is on the mend, now certainly seems like the time to consider equities over bonds. What strikes me as incredible however, is at precisely the point that investors should be looking to equities, they are running from them and instead flocking to bonds. The desire to run with the herd is strong. In this environment however, one must be willing to part from the herd if he or she wants to outpace inflation and preserve wealth.
Ethan S. Braid, CFA
HighPass Asset Management