Conclusions From Reading The Treasury Tea Leaves

by: S. Hilgemann

On April 13th, Seeking Alpha contributor Calafia Beach Pundit published an article entitled "Reading the Treasury Tea Leaves." The article focuses on discussing long term government bond yields and compares them to inflationary expectations, but despite his best efforts the author is frustratingly shy on providing readers with solid investment conclusions derived from the facts presented in this otherwise excellent piece.

This article fills the gap by taking direct quotes from the original and then outlining my personal investment conclusions as to what investors should or should not do in today's market environment.

First quote from the original article:

[...] the CPI has averaged 2.7% per year for the past two years; the 5-year, 5-year forward inflation expectation embedded in the Treasury yield curve is 2.6% today, and has averaged 2.6% over the past year; and the 10-year expected inflation rate embedded in TIPS is 2.3%. So if inflation comes in around expectations, buying the long bond today at 3.15% gives you an expected real return of just over 0.5% per year, whereas buying the 10-year Treasury today gives you a negative expected real return.

My conclusion: Do not touch long-term US government debt

With 30-year US government yields well below their fair-value and 10-year real yields being negative (!), it's hard to see why anyone would think that investing in long-term US government debt at current yields is an attractive investment proposition. Think about it, as an investor in 10-year Treasury Notes you are effectively paying the US government out of your own future wealth (i.e. future purchasing power) to have the privilege to be allowed to lend the country money. That's not just crazy, it's downright financially irresponsible. No wonder Warren Buffett recently warned in his annual letter to shareholders that "right now bonds should come with a warning label". Proceed at your own peril!

Second quote from the original article:

This is why I see today's Treasury yields as a very good indicator that the market is still dominated by fear rather than by optimism. I think the economy is very unlikely to deteriorate significantly, but neither do I see it being very strong. But since the market is dominated by fears of weakness, my view makes me effectively an optimist.

My conclusion: Fear is always followed by optimism - be prepared!

While it is impossible to time the markets consistently over a long period of time, it is possible to recognize when market participants are scared of something and then act upon it. The current low rate environment is screaming "someone is scared," and investors should free themselves from following the crowd and say to themselves, "be greedy when others are fearful," just as Warren Buffett does. By the time everyone is optimistic about the future it will be too late and most of the returns will already have accumulated on early investors' bank accounts.

Third quote from the original article:

But bonds are not always fairly valued, as should be obvious.

My conclusion: Buy Equities while you can

This may not be the most obvious conclusion from the quote above, but here's the logic: We've just come out of a 1 in 100 years financial storm, we are at record low interest rates, and company equity is being priced at 30-year low valuations, whether you look at P/E ratios, P/B ratios, discounted cashflows, you will see that stocks are cheap. Any way you look at it, not only bonds are sometimes mispriced, but company equity can be as well.

I would argue that today both bond yields and common equities as a whole are mispriced. Below is a chart that depicts the S&P 500 since 1982: it shows the price levels in white, the P/E ratio in green, and the P/B ratio in blue (data available from 1994). As you can see, the S&P 500 is as cheap as it's been since 1989 on a P/E basis (around 14.1x), and the cheapest since 1994 on a P/B basis (around 2.2x). These kinds of valuations will not last forever, but while they do investors should get their hands on as much equity as they can.

Click to enlarge

Add to this the possible threat of inflation, courtesy of Ben Bernanke, over the coming decade and you have quite a bit of tailwind behind you as an equity investor. Equity investors' purchasing power should grow nicely if they invest in a sufficiently diversified basket of good companies while they are still cheap. Individual investors should ideally focus on equity indices such as the S&P 500 or the Russell 3000, perhaps sprinkled with some stock picking to satisfy their egos. Professional investors should focus on stock picking, as there are still some incredible bargains to be had out there, if one is willing and able to do the work that is.

Final word: If you absolutely have to own US government debt, hold short-term debt

In the face of rising rates an investor should rather hold no US government debt than any at all, but the reality is that many businesses across the world simply have to have some proportion of their investable assets in US Treasuries. In this case I would strongly recommend that these investments are focused on the shorter-term durations, i.e. Treasury Bills with a duration of less than 1 year. Again we can listen to Warren Buffett for some guidance on what Berkshire Hathaway (BRK.A) does in this regard (also from the recent annual letter to shareholders): "Even so, Berkshire holds significant amounts of them (US government bonds), primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions."

Sound advice from a sensible investor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.