One year and three months ago, on April 17th 2012, I published a Seeking Alpha article entitled "Conclusions From Reading The Treasury Tea Leaves". In my article I made two key conclusions: 1) investors should avoid long-term US government debt at all costs, and 2) investors should buy equities at historically low valuations while they still have a chance to do so.
Since then readers who followed this advice did very well: While the Vanguard Long Term Government Bond ETF (VGLT) generated losses of -4.94%, or -4.08% per annum (assuming dividends were reinvested at all times) the SPDR S&P 500 ETF TRUST (SPY) generated returns of +20.45%, or +16.53% per annum (again including dividends). That's a whopping outperformance of +16.53% - (-4.08%) = 20.61% per annum.
In today's article I will once again review the popular topic of "let's guess what the Fed might do" and show how simple common sense should guide investors to keep doing the right thing: continue avoiding long-term US government debt and continue to invest in US common stocks.
Common Sense Says ...
Common sense is surprisingly uncommon, especially when it comes to the field finance. For some reason most investors like to listen to and read the thousands of opinions that so-called experts throw around in the popular media. Instead I think investors would be much better off if they took a step back, sat down, ignored all the noise and switched on this gift of nature we call the brain.
So what follows is my attempt to cut through the noise, switch on my brain and extract some much needed common sense and distill it into a number of important conclusions that matter to long-term investors.
Common Sense Conclusion #1: Interest Rates Rise Because Things Are Going Well
I hope this makes sense to every single reader of this article. Interest rates won't rise if economic conditions don't allow it, they will rise because the economy will have improved.
Fed Chairman Ben Bernanke recently commented during his press conference on June 19th 2012:
If interest rates go up for the right reasons - that is, both optimism about the economy and an accurate assessment of monetary policy - that's a good thing. That's not a bad thing.
It's important to understand that our policies are economic dependent and, in particular, if financial conditions move in a way that make this economic scenario unlikely, for example, then that would be a reason for us to adjust our policy."
In other words, both the tapering of quantitative easing as well as any future interest rate hikes will be strictly tied to an improving economy. The two are completely co-dependent! One cannot happen without the other. And that's good news!
Common Sense Conclusion #2: We Are At Historically Record Low Interest Rates, There's Only One Way We Can Go, And It's A Long Way Up
You have to be a member of one of the older generations to be able to remember a time when interest rates were continually rising. The 10 year Treasury yield peaked in the 1980s just under 16% and has been falling ever since. The last 30-odd years have been a boon for credit markets as dropping yields have increased cash prices for bonds. An entire generation has been trained to expect bond price increases and yield decreases.
But the future is likely to look very different, and the generation that only remembers the one way traffic of the last 30 years may be in for a shock.
As of today the 10 year Treasury yield has moved off its historic lows of around 1.5% in the summer of 2012 to around 2.7%. While this may seem like a big move to many, in the grand scheme of things it is a tiny little move that bears little effect. The massive amounts of monetary easing we have experienced over the last few years make me suspect that in 10 or 20 years investors will look back at this period and reminisce about the ultra low inflation and ultra low interest rates we currently live in. How high yields will eventually go is anyone's guess, but common sense suggests there's still plenty of room to go (up to 16% perhaps?), while the downside in yields is relatively limited. The longer one's investment horizon is the surer one should be about rising interest rates.
Common Sense Conclusion #3: Long Term Treasuries Are A Bad Investment, Equity Ownership In Good Businesses Will Thrive
In a rising yield environment it's clear that long-term Treasuries are a bad investment as I argued in my article last year. It's a bit like trying to win a marathon race with 10kg weights strapped to each of your ankles; why handicap yourself like that? The coupon payments will barely make up for the losses investors will incur from price changes.
Performance of equity ownership, however, is correlated to economic activity. So if the Fed needs to taper and eventually raise interest rates, then that's only because businesses and the overall economy are doing well. This means that while interest rates may gradually rise over the next decade or so, equities will most likely continue to appreciate.
This is why I continue to strongly advise investors to continue to avoid long-term government debt and continue to invest in US stocks, whether that be through a highly efficient index fund or through individual stock picking of superior businesses with a large margin of safety. Over time investors who heed this advice will do much better than those invested in government debt.