Since mid-May, we have seen a surprisingly rapid decline in bonds. As the Dow and S&P recover from a brief month-long correction that began in May to new all-time high closes this week, many experts are heralding in the long anticipated Great Rotation from bonds to stocks. There appears to be a lot of credence to this call. Bond outflows were historic in the month of June, with mutual funds bleeding and ETFs hemorrhaging beyond what models believed to be even possible. Many analysts have made a U-Turn in the past two weeks from expecting further correction to calling for a breakout to around 1780 on the S&P by this summer.
Since last November, the S&P has run 24%. When compared to foreign equities, metals, bonds, and most commodities (excluding oil), domestic equities have had significantly higher yields than other asset classes. We also know that hedge funds have done much worse than benchmarks in general, and I think it is fair to extrapolate that to investors in general. The case being made is that in a desperate search for yield, investors are ready to pile into the best performing investment. Treasury markets have sold off aggressively on comments from Federal Reserve Board members that have hinted at bond purchase tapering as well as labor market improvements, which have suggested that tapering would occur soon. I don't believe this will prove to be a wise move, and actually subscribe to the thought that long term treasury bonds offer a very attractive opportunity for the second half of this year. This belief stems from the following four factors: 1.) The purpose of interest rates and what effect the recent rise has had on economic activity, 2.) The labor market is not improving as much as recent employment reports suggest, 3.) The historical relationship between the end of past QE programs and bond yields, and 4.) The futility of chasing the "the last 10%," to paraphrase Jesse Livermore.
In approximately 2 months, the yield on the 10 year bond rose from 1.6% to 2.75%. In absolute terms, this isn't a lot, at barely over 1%. We have seen bond yields move like this before, the most often cited comparison recently being 1994. In that year, the ten year rate moved from 5.75% on January 1st to about 7.8% by year end. This represents a 35% rise in yields over a twelve month period. By comparison, since May of this year, yields rose by over 60% to the current cycle high on July 5th. Even though the 1994 move was greater on a nominal basis, it was far less severe on a percentage basis, which means its effect on the margins was not as great. Those who expect this move to mirror previous bond yield spikes in nominal terms are underestimating how effective this rapid spike has been at curbing some of the excesses in the system.
The first quarter of this year was a boom period for high yield bonds, more accurately known as junk bonds. Rates fell to below 5%, according to the Barclays Index, for the first time since 1987, while junk bond issuance globally totaled $149 billion, over 25% above the same period in 2012 and several times the amount issued in all of 2008 during the financial crisis. An increasing percentage of the high yield debt issued was "covenant lite," meaning that even though yields were at decade lows, bond holders were not requiring any protections from issuers to ensure that the companies would be able to meet their debt issuance obligations. Since May, the spread between treasuries and junk bonds has widened, meaning that yields for new issuance are now upwards of 6.5%. The market is more accurately pricing debt risk even as equities continue to act as if everything is fine. Not only is this rarely sustainable, but real estate is showing even greater stress.
Highly levered mortgage REITs have been forced to sell mortgage backed securities as their share price is hammered and investors pull funds out en masse. Friday, July 5th saw the largest single day increase in mortgage rates in history. Mortgage rates have gone up more dramatically than treasury yields with FHA loans (3.5% down) seeing rates rise more than conventional jumbo mortgages. This has caused mortgage purchase applications to fall a stunning 28% in six weeks, according to the MBA. While much of this fall can be related to refinancings, the purchase application index has also contracted significantly. Falling mortgage applications combined with a drastic reduction in purchasing power (every 1% rise in mortgage rates reduces affordability by approximately 10%) will hit hard. In an age where it has become normal to stretch and mortgage as much as possible, this reduction in purchasing power is acute and causes home prices to fall dramatically among marginal sales which will curb the bubble-like home price gains seen in the first four months of 2013 by Case Shiller among others (it is unfortunate that home price data lags actual economic conditions by so long; there really are no good coincident indicators to turn to outside of mortgage apps that I just mentioned.)
Housing bulls will say that mortgage apps and affordability concerns don't play as big of a role this time around because of so many purchases being done in cash only. It is well known that P/E firms, Blackrock being the most famous, are buying housing properties as investments and converting them to rental properties. With flat wages and tight consumer credit keeping a lid on rental rates, the recent housing market boom was already making investment tough. Costs rising significantly faster than revenues result in lower yields. Bruce Rose of Carrington Holding Co., one of the first major names into the REO to rental game, said this spring before the rate rise, in a Bloomberg article, that he was out of the market:
We just don't see the returns there that are adequate to incentivize us to continue to invest. There's a lot of -- bluntly -- stupid money that jumped into the trade without any infrastructure, without any real capabilities and a kind of build-it-as-you-go mentality that we think is somewhat irresponsible.
Some other sobering facts from that Bloomberg article: newer players in the housing investment space such as Colony American Homes had half of their investment properties without tenants. Other players such as American Residential Properties (ARPI) and Silver Bay Realty Trust (SBY) both reported losses in the first quarter. After the mortgage rate increase, resulting in a concordant rise in market discount rates, the investment play looks that much poorer today.
Another strong performing sector in the economy is automobile sales. Auto loans hit their lowest rates ever in May, and the low rates led to a banner first half for the industry, with sales rising to above a 15 million annualized pace in the first half. Several of the gimmicks that were associated with high sales before the financial crisis have cropped up again. Zero percent financing for sixty months is now being offered on the best selling models such as the Ford (F) F-150 and the Toyota (TM) Camry, not just on lesser brands. Subprime car loans rose by 25% in 2012 and continued to increase in the first quarter this year.
By the end of June, Ford had already sounded the alarm bells, saying sales had slowed in the second half of the month. Japanese automakers saw large gains in May; Nissan gained 25%, more than three times the industry average as the Yen weakened against the dollar and allowed the automaker to reduce prices. This really is the other side to the subprime/financing dependent coin showing that sales were dependent on falling prices, which hints that resale values for recent sales are a concern. To cope with increasing car prices, there is a need to produce the strong bottom line results seen by the Detroit 3 in recent years; financing with lower interest rates and longer terms have been used. These loans are very susceptible to rate shocks. It was only five years ago that a credit rate spike and liquidity squeeze bankrupted GM (GM) and Chrysler's financing units when vehicle resale values plummeted. While I am not predicting a repeat, used car values do not have the same price support as prior years. Without bankruptcies like we saw in 2009 and supply shortages for the Japanese automakers seen in 2011 in the aftermath of Fukushima, used cars are not in a shortage like recently. As we have seen, slight tremors are often all that is needed to make things crack. Interest rate rises are needed to flush excesses from the system, and upon being successful, safety becomes more attractive. I expect that to be the case with treasuries at current yields.
Bond bears are in an interesting position when arguing that there should be a rotation into stocks considering that the economy has now spent nine months at stall speed. Q4 of 2012 was an anemic 0.4% annualized growth rate (essentially a rounding error), blamed on uncertainty related to the standoff in Congress over tax hikes and sequestration. Q1 was supposed to be better, but came in at a reduced estimate of 1.8% annualized. Early estimates for Q2 are 1% annualized growth at best. That means for nine months, we've averaged about 1% economic growth. In that time period, taxes have been raised, including a large hit to the lower class with the restoration of FICA rates to their pre-crisis levels, and also on the high end, with households with incomes above $450,000 returning to the Clinton era tax rates. Meanwhile, oil has now rocketed to $106 a barrel and gas prices are headed back over $4 a gallon after being at record high prices for January and February earlier this year. Higher taxes plus higher gasoline prices is a terrible combination for consumer spending, and we continue to see poor consumer demand in the GDP reports.
To justify moving from bonds to equities, the only data point that has consistently pointed to economic strength has been employment. I will ignore the fact that hiring tends to be a lagging indicator of economic growth and instead focus on the internals. From the BLS establishment for June 2013:
Leisure and hospitality added 75,000 jobs in June. Monthly job growth in this industry has averaged 55,000 thus far in 2013, almost twice the average gain of 30,000 per month in 2012. Within leisure and hospitality, employment in food services and drinking places continued to expand, increasing by 52,000 in June.
Forty percent of the job gains last month were in one category, with restaurants and bars accounting for a vast majority of these gains. Two days before that report came out, on the Wednesday before the July 4th holiday, the Obama Administration tried to sneak out, through a blog post, that one of the staples of its sweeping healthcare legislation, the employer mandate, would be delayed one year. Buried within the household survey, we learned why, as it was revealed that 240,000 full time jobs were lost last month while 360,000 part time jobs were gained. CNN Money had an article last week focusing on how restaurants were getting around requiring full time employees being offered insurance, focusing on Fatburger franchises.
"Because a 30-hour work week counts as full-time under Obamacare, Fatburger fast-food restaurants had started cutting worker hours below that threshold," CEO Andy Wiederhorn said.
Some Fatburger owners even began "job sharing" with other businesses, teaming up to share a higher number of employees all working fewer hours. Someone could work 25 hours at one Fatburger, 25 at another one with a different franchise owner, and still not be a full-time worker under Obamacare rules."
Same hours, same pay, same benefits, but two jobs now instead of one. No wonder why leisure and hospitality nearly tripled its 2012 average in job gains last month. Compare that to manufacturing, which has seen job declines for four straight months, and there is reasonable doubt that we are actually gaining 195,000 jobs per months as is being reported. When has the US managed 1% economic growth while hiring at a rate significantly above the rate needed to keep up with population growth? How come the U-6 unemployment rate exploded by .5% and is down just 0.6% for the past twelve months while we gained so many jobs without a particularly large increase in the labor force population? Okun's Law isn't perfect, but it is a reasonable guide here. One percent economic growth cannot result in the sustained job growth that is being reported, certainly not full time, high paying, quality jobs. This is not the environment for dramatic increases in bond rates.
QE has never coincided with a reduction in yields, so a presumption of tapering should not result in the belief that yields will continue to rocket higher. QE1 was begun in March 2009 and ended a year later in March 2010. During that period, the ten year rate rose 2.53% to 3.83%, about 1.3%. Yields then fell to 2.62% (retracing the entire previous move in just 8 months) before QE2 began. When QE2 finished in June of 2011, rates had risen to 3.16%, an increase of about 0.5% (QE2 was the smallest scale QE program). QE2 was replaced by Operation Twist, which was mostly ineffective, as troubles in Europe drove investors into Treasuries as a safe haven in late 2011 and the early part of 2012.
QE3 began last fall and rates were roughly 1.75% and have now jumped to 2.6%, a 0.85% increase. QE3 has been far larger in scope, yet has not had a much larger impact than QE2. The Fed is encouraging risk with QE, not treasury buying, yet those returns are diminishing. The better question is not how treasuries, whose issuance is currently at multi-year lows and now over 100 basis points rich to German Bunds on the long end of the curve, will fare without QE, but how stocks will manage. I tend to believe that QE is the Fed's way of playing the Wizard of Oz. It seeks to create economic growth with the wrong solutions and is as effective at solving our structural issues as pushing on the end of a string. QE's benefits are psychological, and are vulnerable to a change in perception. Even if tapering does to begin, I expect low interest rates to remain without the Fed trying a different tact. Ending zero percent interest rates will end the bull market in treasuries; QE will eventually be recognized as unimportant.
Japan's unprecedented experiment in monetary policy and the resulting weak yen has led to a new round of currency wars. Since the beginning of the year, Korea, India and Australia, as well as many other Asian countries, have dramatically slashed interest rates to answer Japan's opening salvo. Combine that with Chinese weakness spreading across the region and the fact that the US dollar has scored rather impressive gains against Asian currencies. Brazil and Russia have not escaped the pain in the BRICs with underperformance as well. Brazil in particular looks incredibly unstable as massive unrest is spreading into the streets of Rio and Sao Paulo in the past month, while the Bovespa and the Real are being propped up by the Brazilian government.
Contrast that with rising yields and relative stability in the United States, and treasuries look attractive against debt offerings from other sovereigns. If rates continue to rise, the dollar will become that much more attractive versus other options. Not only will that lead to a reduction in competition for US companies, but it has already led to pain for multinational corporations whose sales in foreign currencies are now exposed to losses related to changes in the exchange rate. This is not the condition for continued bond market losses. Foreign investors will once again see US bonds as attractive, which should lead to strength for US debt and falling yields.
Lastly, and this isn't so much as a case for bonds as it is a warning for equities. We are at 53 months of a nearly uninterrupted bull market. Those cheerleaders who herd people into equities have a near term price target approximately 7% above current levels. That would be on top of a 24% gain over the past 8 months, as I said earlier, and a 170% run since the lows of March 2009. If you've missed the past 8 months or the past four years, don't jump in now. A recession and a bear market will happen again. That may not be next week or even next month, but it seems unlikely that the upside from current levels is equal to the risk. The best performing stocks over the past 8 months are not McDonald's (MCD) or Exxon Mobil (XOM). They are not railroads or automakers.
The best performers are the most shorted names, and the tech sector, most susceptible to valuing soft successes such as growth over actual profit and traditional metrics, is outperforming. Success in 2013 has been found by buying stocks in the most tenuous and least sustainable of companies. Gains reflect a change in earnings multiples, a different valuation premium, not a significant improvement in results, especially on the top line. Rotating into equities in a hope that someone will buy the earnings less Amazon (AMZN) for $330 a share compared to $305 is tempting in a rising market. Tesla (TSLA) at over $130 a share when it is making under 1,000 cars a month and was at $30 a year ago eventually, becomes a constant siren song, and unrealized returns are alluring compared to prudence. At some point though, greed turns to fear and euphoria ends faster than seems possible. At times like these, when the market has so mispriced, risk means it also has mispriced safety. We are nearing a time when safety will be rewarded. Invest accordingly.