Winning In A World Without Yield: A Portfolio Level Solution

Includes: FXA, TLT, TZA, UUP, UUPT
by: Michael Allen

Which one of these items does not belong with the others? During the last real stress test of the markets, equities dropped 56.2%. At the same time, high-yield corporate bonds dropped 40.7%. High-quality corporates dropped 24%. Preferred stocks dropped 56.4%. Real estate investment trusts dropped 66.1%. High-dividend stocks dropped 67%. Emerging Market's bonds dropped 33%. Long-term US Treasuries rose 19%.

Unfortunately, that was then, and this is now. The elimination of any respectable yield in the US treasury market alerts us to the end of one of the greatest secular bull markets in recorded history. Finding replacements for US treasuries will be a horrendous task for all investors, and the dearth of alternatives will create ripple effects in all global capital markets for decades to come. Protecting wealth has probably never been more difficult for more people for such a long time as it will become in the next decade or possibly more.

In the search for alternatives, though, it is important to avoid confusing current yield with the real function of treasuries in a portfolio, which is to move in the opposite direction of equities during a contraction or deflationary period. I am going to propose some very unique alternatives that I think will work much better than the obvious high-yield plays and as far as I'm aware, none of these have ever been suggested by any other writer or analyst for quite the same purpose.

The Biggest Mistake

The first mistake that anyone can make is to immediately short treasuries. At current yields, a 10-year bond fluctuates about 8% in price for each 1% change in interest rates. So if the yield is only 1.5, then it takes a change in the interest rate change of 1.5/8 or 0.19 to wipe out the annual interest. The interest rate on Treasury bonds has typically fluctuated by about half of that per week, so 20 bps over the course of a full year is the same as zilch. Therein lies the problem for shorts. The amount that interest rates need to fall for you to lose 8% by shorting the bonds is also, effectively, zilch. The experience with Japanese Government bonds does not necessarily foretell what will happen to US treasuries, and I don't want to get into detailed comparisons here because that would be too far of a digression from my main point. But the JGB story at least offers a worthwhile cautionary tale. Ten-Yr JGBs fell below 1% for the first time in 1998, troughed at .538, and are still below 1% today, more than 12 years later.

There will be a time to short treasuries, but my indicators at least suggest that it is not yet here, and at any rate, the short treasuries call will be a bet on growth and/or inflation and will not relinquish us from our need to find sound deflation hedges.

Some Slightly Better Ideas

What we are looking for is an asset that, like long-term bonds, goes up when aggregate economic demand slumps, but unlike bonds, is not over-valued. There are three very interesting ETFs available to investors now that I would like to suggest.

The first is the US dollar itself. This is represented by the exchange-traded fund with the symbol UUP. You can buy UUPT if you want leverage. When demand slumps, prices go down, and when prices go down, effectively, the dollar goes up. Of course, what you are really doing when you buy UUP is not actually buying the dollar, but shorting a basket of other currencies. The advantage is that this can work even if there is inflation, as long as there is less inflation in the US than in the other countries represented by the basket.

Despite all noise to the contrary, there are really only two reliable drivers of all currency cross-rates: interest rates and inflation. Everything else is pretty much temporary. So if interest rates in the US are nearly zero, then the currency becomes an almost pure play on the relative inflation of each country with added optionality in case the interest rates in other countries come down or those in the US rise relative to the others. In other words, the dollar exchange traded fund gives us the protection against deflation that we seek without the risk of losing money if US interest rates rise. In fact, we gain if interest rates rise. An inflation hedge that benefits from rising interest rates is a beautiful thing.

The US dollar has been in a bear market for as far back as data is available, but as the chart below shows, there have been periods of extraordinary gains, all of which, happen to have occurred exactly when we needed them to happen, i.e., during periods of ferocious declines in stocks. The dollar is a very good hedge. But is it under-valued?

According to the OECD calculations of purchasing power parity, the dollar is indeed undervalued against most of the currencies that make up the basket to which it is compared against to create the dollar index that is represented by UUP.

A small problem is that when you buy UUP, you are actually shorting a basket of other currencies that, as a group, are over-valued, but not every member of the basket is over-valued, so this is a very inefficient trade. There is, however, an even better currency play that is not even in the basket that is used to construct the index. This is the Australian dollar. According to OECD calculations, the Australian dollar, at 33.7% over-priced, is one of the most over-valued currencies in the world and is nearly as over-valued as it has ever been in more than 20 years. When we juxtapose the inverse of the de-trended Australian currency against the de-trended long-bond fund TLT, we find that the deviations from trend are very highly correlated. This makes sense because the Australian economy is very sensitive to commodities that are driven by inflation, so in a deflationary environment, its currency is likely to be the most vulnerable. Since the Australian dollar is inversely correlated to the factor we are trying to isolate and it is significantly over-valued, it makes a lot more sense to short this currency than it does to buy US Treasuries.

And Now for Something Completely Different

Numerous analysts, including Warren Buffet have told us that the solution to low bond yields is to just own equities, but this is simply mis-framing the problem, in my view. Equities cannot replace bonds in a properly diversified portfolio. They are the opposite of bonds, which brings us to the most interesting possibility of all.

If we look back at the last time that bond yields were this low, which was in 1940, stocks subsequently outperformed bonds massively, and this period is the source of reference for most people's belief that stocks are always better than bonds in the long run. A young Warrant Buffet made his first billion in this period. But that period began with record low margins on corporate profit and record low P/E ratios. Today, we have record high margins and only average P/E ratios based on the current earnings. But long-term investors can count on the profits declining significantly at some time during their holding period. Those interested in an argument for why this margin is likely to drop sooner rather than later, can refer to an excellent argument by James Montier of GMO.

My job is to help you make money no matter what happens, so plain and simple common sense requires me to normalize the earnings before calculating the P/E ratio. On a normalized basis, then P/E ratio is still well above any multiple that prevailed any time before 1990. So stocks are not priced to deliver the kind of long-term returns that they did in the 40s, 50s, and 60s, and anyone suggesting that you replace your bonds with stocks is just irresponsible in my opinion.

If you reframe the problem from one of trying to figure out which asset will outshine the other, which you probably can't do, to one of just trying to find assets that will protect you from specific risks and are under-valued, then the obvious solution to the bond problem is not to buy stocks but to short them. There is no asset class more likely to perform well in an environment of declining demand, and probably no asset class that is more "under-valued" than Short-US Equities.

Being short equities as a replacement for our Bonds creates a problem of its own, namely, that having solved our bond problem, we have now need to hedge against the possibility of unexpected growth, but that is a discussion for another day.

Disclosure: I am Long TZA and short FXA.