As they have so many times in recent days, stocks eked out a gain on Tuesday. The pattern of trading has changed a bit, though. Last week, the major averages rallied back after early weakness, but both yesterday and today have seen the opposite occur. With all the averages at or near post-Lehman highs, it will be interesting to see if stocks can maintain their momentum in the face of rising interest rates. Perhaps investors are trying to rationalize the back up in rates as good news in that they imply the economy is healing. But what if falling bond prices are sending a different signal? What if the money-printing that has boosted stocks also means the 30 year bond bull market is over? PIMCO’s Bill Gross made this very prediction in his November Investment Outlook. The words he penned six weeks ago are worth another look, especially since he describes so well why the lack of political will in Washington will matter to all investors — not just to those who clip coupons.
U.S. stock index futures were higher before the opening bell in each of the last two sessions. Monday’s levitation celebrated the lack of an interest rate hike in China, while this morning’s boost was attributed to better than expected retail sales figures for the month of November. The latter was especially interesting in light of Best Buy’s earnings miss cum guidance reduction this morning. Investors didn’t let BBY’s woes spoil their fun in the early going, and the indexes rallied 0.5%. The party hats came off during the afternoon when not only did the FOMC have little new to say after its meeting, but bond prices continued to tank. Yields climbed 20 basis points or more in the middle of the coupon curve. Bonds are now pretty oversold and due for a bounce, but I think rallies should be sold, not bought, going forward. Like equities, the U.S. dollar seems unconcerned about rising long term rates, and the dollar index rose 0.1% today. Commodities also finished nearly unchanged as early rallies faded in the afternoon. Most components of the CRB were mixed on Tuesday, leaving he index itself with a fractional loss.
Unlike fine wines, most market predictions do not age gracefully. Try to recall, for example, what the average CNBC guest was saying about bonds six weeks ago. For every harsh word uttered about fixed income securities back then, you would have heard 10 or more kind ones about “super-safe” Treasurys. But just as Americans were preparing to head to the polls for the November elections, PIMCO’s Bill Gross made the stunning prediction that the November 4 QE II announcement would probably mark the end of the 30 year bull market in bonds (see below). This was no 98 pound weakling kicking sand in the face of the bond market, either. Bill Gross is the Charles Atlas of bond managers, and, prior to the launch of QE I, his firm had more fixed income assets under management than did the Fed itself.
In the three fortnights that have passed since Mr. Gross offered his prognostication, bond yields have indeed risen — probably faster than even the PIMCO chief thought they might. The yield on the benchmark 10 year note is closing in on 3.5%, or 100 bps higher than the day QE II left the dock. Is it really the end of the bond bull market? If so, what (aside from the obvious “avoid Treasurys”) are the investment implications? As for the first question, I agree with Mr. Gross for three reasons. First up is the Fed’s latest adventure in money-printing, a.k.a. Quantitative Easing. Or, as Mr. Bernanke would have you believe, the Fed is simply purchasing Treasurys. His statement, “We’re not printing money” on 60 Minutes last week is as good a reason as any for investors to hit a Treasury bid. The statement was so head-scratching that it caused Jimmy Rogers to wonder aloud the following during a recent Bloomberg T.V. interview: “I don’t know if he (Bernanke) is a liar, a fool, or both”.
The second reason to avoid bonds like they are a communicable disease is the recent behavior of our leaders in Washington, D.C. Our elected officials have managed to redefine the word, “compromise”. Republicans were hoping to extend the Bush era tax cuts and push for the gentlest of estate tax levies, while the Democrats were hoping to extend unemployment benefits, push for middle class tax cuts, a payroll tax holiday, and certain corporate enticements to create jobs. Since Mr. Obama holds a veto pen, the common wisdom among pundits was that any compromise would force each side to give up something in order to forge a deal. What was forged instead was an entirely new way to “compromise” — give both sides everything they want! Compromise implies that one or more parties sacrifice something in order to receive something in return. This “deal” involved no sacrifice (except by our children & grandchildren) of any kind, since both sides received everything they wanted. It is more accurate to call this deal what it is: a “bidding war”. The whole episode caused a friend of mine to remark, “we couldn’t really afford either side’s ideas, so doing both is really pretty scary if you are a creditor of the U.S. government”.
The last reason bonds may once again become the “certificates of confiscation” they were called three decades ago has to do with pricing and positioning. By virtue of their long bull market, bonds have become considered the “safe” alternative to equities, commodities, and other asset classes. Nervous? Just buy Treasurys, says your financial advisor. Just don’t pay attention to the tiny yields, which — even after the recent run up — don’t offer anything like a margin of safety for long term investors. Though there are fewer of them today than there were six months ago, many dividend paying stocks still yield more than every point on the Treasury curve. What’s more, dividends can rise (or fall) as corporations adjust to changing business environments. Coupons are fixed, though, come hell or high inflation.
Not only should bond pricing give one pause, but seeing individual investors pile into bonds in recent years should also cause one to leave the “buy” key unstruck. According to the Investment Company Institute’s latest data (through October, see below), bond mutual funds have received approximately $20 billion worth of inflows per month since the financial crisis erupted. Domestic equity funds, on the other hand, have seen net outflows over the same period. Obviously, not all investors are mutual fund investors, but these figures are a more accurate portrayal of retail investor sentiment than can be found in any poll. That so much money has rushed into bond funds of the type run by PIMCO makes Mr. Gross’s prediction of a bond bear market all the more remarkable. Just as chilling is his description of U.S. government finance and its “Ponzi-like” characteristics.
Two years ago, Bernard M. Madoff revealed that he took Charles Ponzi’s notion of an investing “scheme” to heights unimagined by its inventor. What his clients thought was $50 billion in real money simply vanished. Though I am saddened at the recent loss of his son, Bernie Madoff has rightly been the object of scorn these past two years for erecting what was the largest Ponzi scheme in history. He didn’t hold the title for long, however, since the U.S. government — aided and abetted by the Fed — now holds this dubious honor. Bill Gross is right. When it comes to Ponzi schemes, Bernie Madoff is a piker compared to Uncle Sam.
— Jack McHugh
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