While the mantra on Wall Street continues to be for higher rates, economic fundamentals continue to point to a resumption of the grind lower in long term yields.
I believe long term Treasury yields will fall much further than anyone is predicting right now.
Market valuations are bordering on the absurd as indexes continue to gain assets, and valuation continues to be a secondary concern as T.I.N.A. continues on Wall Street.
This is going to be a two part series on the reasons to own U.S. Treasury bonds. In Part I, I will examine T.I.N.A. (There Is No Alternative) and market valuations. In Part II, I will explore the failure of bond bears to predict the end of the bond bull market, economic data further proving the case that zero coupon U.S. Treasuries are the investment of choice going forward, and that Treasury yields may fall further than even I am predicting.
Equity TIPS? Now This Is Getting Ridiculous
I was recently listening to a financial speaker who was talking about what retirees should do to meet the demands for growth and income in their portfolio. The individual made the argument that equities continue to be the place for retirees, arguing that bonds have no place in a portfolio at these low rates, and companies have more cash than ever before, and are in essence "equity TIPS", which allow investors to keep pace with inflation and offer better growth than any other asset. Now this is getting ridiculous. The notion that a 65-70 year old investor should be putting their life savings 100% in equities, at nearly 22x earnings, with risks asymmetrically tilted to the downside, on the basis that there is no alternative, and with the dividend they can keep pace with inflation, is pure nonsense.
Notice this argument does not even mention the risk of losing 50% or more of your life savings. Investors choosing to overweight equities because of the false notion that there is no alternative, are failing to understand that they are taking a greater and greater risk of significant loss with index funds the higher and higher valuations go.
There is no guarantee on the dividend you are set to receive nor is the price at which you can sell your index funds guaranteed; there is no maturity date on U.S. Equity Index Funds. There is no guarantee of anything with an equity index. Even the universally accepted notion that an equity risk premium will provide investors with a premium return is not guaranteed. In fact from 2000-2010 investors in the S&P 500 received a cumulative total return over an 11 year period of just 3.61%, far below the 189.03% for long term zero coupon U.S. Treasury bonds over the same period.
I am not making the argument that investors should not own equities, currently we are 35%-40% in equities, with a P/E on the portfolio of 11x versus 22x for the S&P 500. I am comfortable with what I own and the prospects for the companies I am invested in. But the vast majority of the portfolio's assets continue to be in zero coupon U.S. Treasury bonds at the long end of the curve for many reasons, the first of which is current market valuations.
Market Valuations Are Obscene and Continue to Get Worse
We are in a serious period of time that is not being taken seriously by investors. This is largely because central banks have decided to backstop equities, and train the investing public to always buy the dip. As a result you have pushed volatility to obscene lows, with the VIX hitting a low of below 9, a new record low. So you have now corrupted the very underpinnings of capitalism, and free markets, where fear and greed have been replaced by the often cited phrase "don't fight the Fed". The Fed continues to push market prices to levels rarely seen in history, and with it the danger grows.
Currently the stock market remains significantly overvalued, by an average of nearly 100% from the mean. Investors and advisors should think twice before putting hard earned capital in a market at such obscene levels.
Far too often I hear the same mantra, that valuation does not matter and markets can keep going higher and higher. While this is true, as none of us has a crystal ball, this is certainly not a market where any form of "investing" is taking place; we have entered a world of pure speculation induced by central bank policy. Index funds have certainly played a role in this speculative market as the inflows to index funds continue to push the same group of stocks higher.
In addition, we are seeing more and more professional investors returning money to investors as the opportunity sets continue to be limited. Obviously professionals can see the obscene valuations that other market participants can not see. Seth Klarman of Baupost Capital recently announced he was returning capital to investors. Baupost also continues to hold 42% of their assets in cash.
In his 1991 book "Margin of Safety" which has become a value investment of its own (copies can go for as much as $6k online), Klarman brings investors back to first principles of value investing by describing the disconnect between investing and indexing. The quote is lengthy but worth the read.
To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that "in any sort of a contest -- financial, mental or physical -- it's an enormous advantage to have opponents who have been taught that it's useless to even try." I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted.
Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis. Indeed, at the extreme, if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them.
Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers.
Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index.
I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. More significantly, as Barron's has pointed out, “A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing."
When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits."
Valuation No Longer Matters
What I find particularly troubling is the legion of index proponents who have actually made the argument that investing has nothing at all to do with valuation, as if these are not real businesses.
These participants in the market believe in investing in every market environment, regardless of valuations. I am not a market timer, and again I will concede markets could continue rising, but I ask you a simple and logical question: If this money is for your retirement, is it really prudent to continue to buy equities at what could be the top of the market at 22x earnings, and risk losing 30% or 40% to make 5-10%? I would say no.
Each additional unit of return can only be acquired by taking an ever greater risk that the music will stop, and this game of musical chairs leads to a stampede for the exits. Because everyone increasingly owns the same index funds, and since they all own the same securities in the index, the carnage is likely to be magnified. It is time for investors to get serious about analyzing the risks in their portfolio.
The market as a whole is expensive; this is not up for debate. If you are buying index funds at 21.9x earnings on the S&P 500, and putting new capital in at these levels, your returns for the next decade will be below 1%, and your risk to attain that return is enormous. Those who ignore this are demonstrating a severe bias and hubris in their investment process. Stocks do not go up forever; winter is coming.
Having these conversations with index fundamentalists borders on the absurd as they continue to insist that 80-100% equity portfolios are preferable in this age of "reflation". Economic analysis and security valuation is clearly of no use to these index speculators who continue to pour money into index funds with no regard for the fact that we are at valuations that have only been higher once before, in the tech bubble.
The current market has nothing at all to do with investing. Presently, participants continue to speculate on the future value of risk assets, assured that they must be worth more than risk-free bonds. While there is a limited opportunity set for true value investors, opportunities do exist, but the vast majority of the market continues to trade in a vastly overvalued state. This is all the more reason why the majority of an investor's portfolio would be far better off invested in zero coupon U.S. Treasury bonds at this time, which have beaten the equity indexes and will likely continue to do so.
The Liquidation of Corporate America Is Underway
I began my career in accounting for complex financial instruments, and having that foundation has been invaluable in being able to figure out what is going on in a company's financial statements and with a business in general. I read every footnote and try to understand the methodology that companies use to formulate their earnings or generate further revenue now and prospects for the future.
I think that there are many ways for me to analyze businesses whether through ripping apart their financial statements, studying the footnotes, or merely looking at industry trends and opportunities for growth. What I am seeing right now in corporate America is very troubling, and I am certainly not the only one.
Instead of investing in the future and using cash for productive ends, what we are seeing is corporations taking the short term view of having a higher stock price each year and a better dividend yield. So companies are hoarding cash and borrowing money at ultra low yields to pay out dividends and perform stock buybacks. In a 2015 article in the New York Times, Larry Fink, CEO of BlackRock stated: “...companies in the Standard & Poor’s 100-stock index are paying out 108 percent of their earnings to shareholders. That can't last.”
Corporations are in a sense liquidating themselves. By focusing on the ultra short term and not focusing on investing in property, plant, equipment, innovation, or any type of long term thinking, companies are taking your money in at 20x earnings and leveraging it to provide you with a return that is generated through financial engineering, fueled by ultra low rate debt. We will see easy credit lead to problems in the real economy again just as we have over and over again in the recent past. This time is not different.
In 1999, we were told that companies could earn no money, and yet sell well beyond their values because the future prospects were unlimited. This period of time was funded by easy credit to start companies that resulted in a tech bubble that saw the Nasdaq stock market fall 82%.
In 2008, we saw easy credit in the form of mortgage debt where no verification loans resulted in a housing bubble on the notion that housing prices never come down. This resulted in a stock market crash that saw the Dow Jones Industrial Average fall 49%.
Today, we are seeing an environment where excessive extraordinary Fed policy, characterized by low interest rates, has driven risk assets to all time highs, on the notion that there is no alternative to stocks. Corporations are borrowing like never before to fund buybacks and dividends instead of investing in productive ends. How will things end this time? If history is any judge, not well. The danger in 100% equity portfolios is very real, this time is not different; it never is.
Zeroes vs. 100% Equity
Investors are pouring dollars into equity indexes without any thought to valuation, aided by the passive advising community, which just like in 2008, will eventually be confronted with the question "how did you not see this coming?" I take the responsibility of providing advice to others very seriously. Investors can not afford to see a lifetime's worth of working, saving, and sacrificing vanish for the mere prospect of higher returns.
In reality the higher returns that we are promised by equity index advocates only show up if you buy and sell at the right time. How did this work out for those who began retirement in 2008 and saw half of their life savings vanish, and their dreams of a secure retirement go with it? Investors who held 100% equity portfolios in 2008 and retired have seen their life savings come back from the bottom and double, this is true, but it took them until 2013 to get back to even.
|Portfolio Value in Retirement||$1,054,900.00||$637,598.44||$787,765.62||$885,498.98||$858,239.78||$957,795.59||$1,226,131.60|
|4% Withdrawal Rate||$42,196.00||$25,503.94||$31,510.62||$35,419.96||$34,329.59||$38,311.82||$49,045.26|
|Balance Less Withdrawal||$1,012,704.00||$612,094.50||$756,255.00||$850,079.02||$823,910.19||$919,483.77||$1,177,086.34|
|Vanguard Total Stock Index Returns||5.49%||-37.04%||28.70%||17.09%||0.96%||16.25%||33.35%|
What I really want you to notice in the data is the drop off in income. If you use a traditional 4% withdrawal rate the income drops from $42k per year, down to $25k per year. Any investor depending on that income may have been forced back into the workforce. We are also assuming that they stayed invested, and we know many did not.
The realities of over-allocating to stock index funds are not considered by many who have chosen these types of portfolios. I am merely saying, be very serious, this is for your retirement, and I do not think you can really afford to take the kinds of risks you are taking with the hopes of capturing some equity premium that may turn out to be a myth.
Let's see how investors would have fared in a balanced allocation of 50% zero coupon U.S. Treasury bonds, 50% Berkshire Hathaway (BRK.A), which is a representative security for the value principles of Benjamin Graham, versus the Vanguard Total Stock Market index fund (VTSMX).
|Long Term Zero Coupon U.S. Treasury Bonds||430.98%|
|Berkshire Hathaway Stock||615.90%|
|Vanguard Total Stock Index||352.48%|
|50%/50% Allocation of Zeroes/BRK.A||523.44%|
|100% allocation to Vanguard Total Stock Index||352.48%|
What is most important to note from this data is not that the 50/50 portfolio outperformed. I know there will be more than a few who criticize the selection of Berkshire Hathaway as a representative security for value investing, but the real takeaway that investors should focus on here is the fact that zero coupon U.S. Treasury bonds would have provided safety of principal and returns, which outpaced the total stock index over the past 20 years. At a time period where we have seen such rapid innovation in technology and massive quantitative easing by the Fed, all favorable to stocks, bonds still beat stocks.
Investor Behavior Indicates Even Lower Returns
The argument consistently made by equity-only portfolio advocates is that the S&P 500 has done significantly better than the risk free rate over the past 20 years. I have proven this to be incorrect and in fact Treasury bonds have outpaced the S&P 500, but more importantly is the notion that you, as the investor, are going to get the return stated in the index fund literature.
It assumes that you buy at the right time, and sell at the right time, and capture the return offered by the market for a given period of time. From studying research, and more importantly working with real investors, we know they probably don't do that. Investors notoriously misstate their risk tolerance. Motivated by greed, they get entrenched into believing they can take on more risk than they really can. Then when the market begins to fall, they sell at the worst times. This distorts the amount of return they actually capture, making the index fund argument even weaker.
The notion that the investor in academic studies, who is perfect and represents a "passive" investor, has anything to do with investors in the real world has been shown by academic research, no less, to be a failed notion upon which many other theoretical models depend.
A 2011, study by researchers in the University of California system found that
"The investors who inhabit the real world and those who populate academic models are distant cousins. In theory, investors hold well diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. In practice, investors behave differently. They trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by media and past experience."
Since 1994, DALBAR has been conducting research into investor behavior in buying and selling decisions. In their "2016 Quantitative Analysis of Investor Behavior" report (QAIB), they found that while the market itself was up 11.96%, and index funds were up 11.82% after costs, investors on average, only captured 7.26% of that return. Over a longer period of time, the S&P average return was around 7.68%, yet investors only captured 4.79% of that return, only 62% of the total market return.
Therefore, it would stand to reason that if the Fed withdrawing its easing program will lead to increased levels of volatility as we are told, then that will result in a larger percentage of investors reacting to volatility and buying and selling at the wrong times. This will thus lower the total return, on average, that is realized by investors in American markets. With a P/E 10 at 30.55, and future returns forecasted to be around 1% or below for the next decade, this would mean that investors can expect to realize negative returns over the decade when their behavior is incorporated. All the more reason to trust the majority of your portfolio to zero coupon U.S. Treasury bonds.
Until price discovery based on fundamentals, not Fed induced financial engineering and index fueled speculation, is restored to the capital markets, long term zero coupon U.S. Treasury bonds remain the investment of choice for the discerning investor seeking to preserve and grow their wealth.
In Part II, I will explore the global economic data and further the growing case for Long Term Zero Coupon U.S. Treasury Securities, and lower long term Treasury yields.
Disclosure: I am/we are long BERKSHIRE HATHAWAY, ZERO COUPON U.S. TREASURY BONDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.