My grandparents, as gracious as they were, would put me in their laps and reminisce on the days of old. They would speak of local folklore and recollect stories of their childhood. What always amazed me were the prices of the goods and services. Most basic items were not priced in dollars back then but rather cents and tens of cents. Now, as an adult, the same astonishment overwhelms me as I look at the U.S. 10-year and 30-year yields. When my grandparents were in their prime, the U.S. endured a stagflationary environment, where the 10-year yield was around 7% in the 1970s and peaked at 15.68% in 1981, during the tenure of the Fed Chairman Paul Volcker, as seen in the chart below.
When people of my generation look at the level of 10-year Treasury yields today, the contrast is staggering. Currently the U.S. 10-year Treasury yield is around 1.7%. I ponder whether I will be like my grandparents, speaking of when I lived in a time of low yield. Using the ETFs [[IEF]], the iShares Barclays 7-10 Year Treasury Bond Fund, and TLT, iShares Barclays 20+ Year Treasury Bond Fund, as gauges, yields are at 1.33% and 2.72%, respectively. Furthermore, YTD the ETFs have appreciated in price by 4.05% and 4.32% respectively. This seems anemic compared to the S&P 500 (SPY) which has a YTD return of approximately 16%. My tales will encompass a low-yield, deleveraging environment, in a post-global financial crisis equity bull market, with the moral of the story being taking a long position in SPY versus IEF and TLT.
The Fed, led by Chairman Ben Bernanke adopted several policy tools to mitigate the effects of the global financial crisis. It dropped its benchmark rate, the Feds Fund rate, to 0-0.25% and expanded its monetary base through the facility of quantitative easing (QE). The Fed's objectives were to provide stability and liquidity during the time of crisis. While it can be said that the measures were successful, one of the effects from the crisis and the Fed's policies has been the declining yields in US Treasuries, which proved to be profitable for investors. To put things into perspective the 3-year price returns of IEF and TLT are approximately 8% and 12.05% respectively.
Since the crisis subsided, the Fed has been attempting to bring the US economy back on track, implementing to date three iterations of QE. While the first two QEs targeted the purchasing of US Treasuries, the ongoing QE3 only focuses on the purchase of MBS, thus subduing only mortgage rates and specifically targeting the consumer rather than overall yields. These new initiatives by the Fed, through QE3, places US Treasuries in a less favorable position, as the bid levels for these facilities are lessened. As such, IEF and TLT may not perform as well as they did in the past three years.
Compare and Contrast
Another effect of the Fed's low-yield environment has encouraged investors to venture into assets other than US Treasuries. In my previous article, I offered an alternative to US Treasuries: Canadian bonds. The more traditional approach, especially for investors with balanced portfolios, is investing in the US stock market. Taking into consideration the current interest rate environment and where price earnings in the US are positioned, SPY remains much more attractive. The 12-month distribution yield of SPY stands at a competitive 1.98% while the 12-month distribution yields of 7-10 year US Treasuries and 20+ year Treasuries are 1.99% and 2.80% respectively. Furthermore US Treasury yields are currently at historical lows while from a price earnings perspective, SPY is not breaking barriers. SPY's P/E averages 13.79 for the past year and SPY typically enters overvalued territory around 15 times earnings. For the past 12 months SPY's P/E high was 14.91. The chart below displays the one year P/E of SPY.
Source: Bloomberg Terminal
SPY has more room to appreciate than the ETFs IEF and TLT. With SPY producing similar yields to IEF and TLT, the choice in asset allocation seems simple: equities over bonds, SPY over IEF and TLT.
While in the medium term the IEF remains in an upward trend, in the short term (up to three months), the trend is range-bound at best. Resistance is seen at the US$109.89 price level and support is at the US$106.42 price level. The distance between the support and resistance levels is approximately 3%. The short term chart of IEF can be seen below.
Similarly to IEF, TLT remains in a medium-term upward trend; however, in the short term, price movement has been to the downside, with TLT finding support around the medium-term upward trend support line at the US$120 price level. Currently, TLT is testing medium-term resistance at the US$123-125 price level. My estimates are for TLT to fail to break above this resistance zone and retest the support trend line. Displayed below is the daily chart of TLT.
SPY remains in an upward trend both in the medium and short term. The ETF is currently experiencing a short-term pullback from its highs of US$148.11 and is expected to test support around the US$142.16 price area, making it a viable position for re-entry. The chart below shows the daily chart of SPY.
Talking to My Grandchildren
Hopefully, when I am in the twilight of my life, I will not only be able to talk to my grandchildren of Anansi stories (West Indian folklore), but rather of the choice of purchasing companies over debt. While the latter may not be as entertaining as the former, hopefully my grandchildren will absorb the anecdote and do the necessary analyses in order to execute on the proper decisions given their economic environment.
Additional disclosure: The views expressed in this article are my own and are not necessarily the views of any companies or organizations I am affiliated with. I expressly disclaim all liability in respect to actions taken based on any or all of the information in this writing.