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Counter Case… Denied

As posted:

In our Blog pages, we have argued many times that we believe the long-term case for stocks on a risk/reward basis is much greater than bonds - particularly government bonds. However, I am a man of presenting both sides of an issue. I saw this Forbes interview with Gary Shilling, and I soooo wanted to present it as contra-case for bonds and against equities. However, the case and subsequent advice in this interview/article is so flawed, I just couldn't do it.

Let me start with this caveat: Mr. Shilling, president of A. Gary Shilling & Co., author of The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation and a Forbes columnist, predicts that the 30-year Treasury rate is going to 2% and the 10-year is going to 1%. If that turns out to be true, then yes, you will have wanted to be long treasuries and most likely short stocks (given the circumstances that would have to have occurred to lead to us those yields). If the long bond goes to 2%, holders will in fact see a 24.6% capital appreciation. Currently, the all-time low in the 30-year was 2.458%. Granted, that level occurred last July.

I am not in the prediction business. I can't tell you when or what level prices will be achieved. However, I can tell you that rates can not stay at those levels forever. You would have to be a particularly daft trader to capture that type of return. Instead, I look at the risk versus return. As many could argue for long-term rates at 4.5% as those that argue for 2%. Those that hold 30-year treasuries would experience an equal 24.6% capital loss if rates returned to levels seen in 2011. And rates could easily remain there. Over time, rates could go significantly higher, and the capital losses would be greater.

Since 1981, the year Mr. Shilling states he began investing, the treasury rates have been on a 30-year secular bull run. Rates are (most likely) bounded by zero, meaning there is only a limit as to how much they can go down. But history has shown the levels in which it can rise to. Therefore, the histogram of possibilities is hugely asymmetric to the bad side. And even with historically abnormal run in bond returns and a lost decade for equity returns in the 2000s, stocks still outperformed bonds during that run. As we pointed out in our blog post, Really Nominal, the aggregate expected real returns in government bonds is zero.

I don't mean to disrespect Mr. Shilling. He makes some significant and compelling points in the interview. His discussion about financial leverage and real GDP are both interesting and educational. His comments regarding bubble conditions in junk bonds and other corporate debts are quite valid.

Forbes: So do we have a bond bubble outside of treasuries today or are treasuries part of the bond bubble?

Shilling: We definitely do. If you can believe this, 46% of junk bonds are selling at or above call. In other words, they are selling at or above a price at which the companies can call them back. And of course they call them back as soon as they can because they can reissue the debt even cheaper. Another thing is the difficulty with which a low-grade company has defaulting. It takes real skill to default today because there's so much money thrown at them. And this is, in my view, clearly a bubble.

Mr. Shilling's own prediction is predicated with its own preposterous caveat. His ultimate belief (as seen by his rates prediction) is that investors should be positioned long in bonds, and short (or no exposure) to equities. However, prior to reaching that ultimate asset allocation, one should time the market.

Shilling: Well, yes. I think right now, as long as you have the risk on and people are enamored with stocks and the grand disconnect is there, what we're suggesting is being long equities, but selectively and cautiously. In other words, I like things like consumer staples. I like companies that pay high rising and sustainable dividends…

Forbes: Now in terms of stocks, you see the grand disconnect ending. What you still want to be in dividend-paying stocks?

Shilling: No. No, at that point I think you want to be out of stocks pretty much entirely.

Forbes eloquently responds, "So you have a very delicate timing issue here."

You have to be ready to really shift gears and get out of stocks and go heavier into treasuries and certainly avoid or go short things like junk bonds and emerging market bonds, more commodities, things that are right now in demand with the risk-on, with the grand disconnect in full flower.

So in the end, the suggestion is that bond yields are going lower, but only play that card when its obvious. I hate to break the news, but by the time you know the apparent grand disconnect is over, it will be too late. Instead, stick with long term strategies and watch the risk/reward. Market timers and prognosticators all have their moments, but thoughtful and dedicated long-term investors end up the winners.