The Insane Market Hypothesis

Includes: KO, SPY, TLT
by: Skyler Greene

A long time ago, someone proposed that the market was "efficient." I'd like to counter-propose another idea: the market is clinically insane.

That's the only way to describe the phenomenon seen recently in equity/bond flows. According to Reuters, investors are dropping equities like they're hot potatoes:

Equity funds recorded net outflows of $11.27 billion in the week [ending July 25], the biggest exodus since September last year, including $9.216 billion exiting from exchange traded funds.

And where is all this money going? Why, bonds, of course:

[In June] U.S. stock funds experienced outflows of $8.5 billion, versus $10.8 billion in inflows to taxable-bond funds and $3.8 billion to municipal bond funds.

The fear trade has sparked a full-on rampage into bonds, regardless of the fact that investment-grade bonds are in an undeniable bubble. In an interview with CNBC, James Grant observed:

This is not the apocalypse. This is kind of okay, life goes on, and yet we have interest rates pitched well below measured rates of inflation. It's muscle memory... 31 years and counting [of the bond bull market].

In response to a question about the call last year by Bill Gross that bonds were in a bubble at 2.5% yields, Michael Harkins added:

Isn't this marvelous? You never get a bubble to go absolutely crazy until you can get a moment where people say "yeah, but you said that last year, it didn't work." That's how you get the grounds of the Japanese palace to sell for the price of all of the state of California, theoretically. That's how nutty it got in 1988-89, in Japan. You're exactly right, at two-and-a-half percent, it seemed impossible the rates were so low, now they're one-and-a-half and we're denying arithmetic. That's how you know we're in a bubble.

As certainly as tech stocks were in a bubble in the late '90s, so are Treasury bonds in a bubble now. As I've analyzed previously, the 30-year rate is already at the point where investors are, best case scenario, breaking even with inflation for the next 30 years. That's ridiculous. Who ties up their cash for 30 years to not even keep pace with inflation?

Analyzing The Argument For Treasury Bonds

While holding short-term (1-3 year) Treasury bonds might make sense for a cautious investor looking to park some cash, holding long-term bonds like those in the iShares 20+ Year Bond Fund (NYSEARCA:TLT) makes absolutely no sense. With interest rates at literally record lows, any investor planning to hold the position for any significant amount of time will take a significant haircut on the bond price, thus forcing them into a situation where they have to hold it to maturity to avoid taking the loss.

The only argument for holding a long-term bond is that your principal will be preserved and returned at maturity. However, with blue chip stocks like Coca-Cola (NYSE:KO) providing a better dividend yield than the 30-year Treasury, you have to ask yourself if you believe Coca-Cola stock won't preserve your capital over 30 years. True, Coca-Cola doesn't have the advantage of fiat currency and guaranteed solvency, but I'll take my chances - to me, it looks like Coke has a pretty solid printing press of its own.

KO Cash and ST Investments Chart

KO Cash and ST Investments data by YCharts

Even assuming a 0% real return, Coca Cola's stock does something the 30-year Treasury bond won't - it stays indexed to inflation.

Given these circumstances, the money flow makes absolutely no sense, and is a clear sign of a bubble. The bond bull market is over; over the next 30 years, SPY (NYSEARCA:SPY) is a lock to return more than TLT (TLT). Bonds are a time bomb. The question isn't if the bubble will burst - it's when.

The only way to interpret the facts: the market isn't efficient. It's insane.

Disclosure: I am long (KO). I am also short TLT (TLT).