Sanford C. Bernstein & Company Analysts (January 2017)
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria”
Sir John Templeton
“Life and investing are long ballgames.”
I have been bearish on bonds since 2016, expecting higher long-term bond yields, and after a promising start in 2016, this has been a difficult trade, as the lower for longer narrative has continued to gain traction, remarkably almost 40 years into the current bond bull market, and even with the S&P 500 Index, as measured by the SPDR S&P 500 ETF (SPY), up over 275% over the past decade.
During this time frame, meaning the past ten years, the iShares 20+Year Treasury Bond ETF (TLT) has actually risen a little over 100%, a somewhat surprising development considering the elevated level of bond prices following the Great Financial Crisis that spanned 2007-2009.
Bond prices and stock prices are rising together, in my opinion, because the U.S. stock market has become more yield-oriented than ever, so lower bond yields help a current dominant driver of the stock market, where many investors - institutional and retail - are focused on dividend yield, as they have been pushed out of the risk curve ever since central banks brought short-term policy rates to near zero levels.
Adding to the narrative, we cannot forget that the large-cap technology stocks like Amazon (AMZN), Facebook (FB), Alphabet (GOOGL), Apple (AAPL), and Netflix (NFLX), are actually the longest duration assets in the stock market, so an environment of rising bond prices (lower bond yields) is a natural driver of out-performance for these companies share prices, particularly in a world where disruptive growth companies are bid up because there is a lack of overall growth opportunities.
Expanding on these last two paragraphs, U.S. stock prices in general have become a safety trade, the end recipient of global capital flows, as the depth and breadth of the U.S. markets, alongside their out-performance, have combined to be a magnet for global capital flows, particularly from Europe and Asia.
Will U.S. bond prices and U.S. stock prices keep rising together forever?
The answer is a firm no, from my vantage point, and this development is going to have important ramifications, particularly for many who have come late to the party for yield-oriented investments.
U.S. bond prices are poised for a generational bear market, meaning higher bond yields.
A Remarkable Run Of Performance
Global financial markets bottomed on March 9, 2009. Since that day, the SPDR S&P 500 ETF has risen 369%, the iShares 20+Year Treasury Bond ETF has risen 74%, the iShares MSCI EAFE ETF (EFA) has risen 153%, the iShares MSCI Emerging Markets ETF (EEM) has risen 117%, and the SPDR S&P Metals and Mining ETF (NYSEARCA:XME) has risen a paltry 30%.
(Source: Author, StockCharts.com)
Taking out the first 3 months and a day rise following the bottom in March of 2009, looking just at the past ten years, TLT has outperformed everything listed earlier but SPY, rising over 100%.
Thus, U.S. longer-term bonds have outperformed both international developed market stocks, emerging market equities, and economically sensitive metals and mining stocks over the past decade, a noteworthy accomplishment in a supposed broad equity bull market.
The relative out-performance of TLT (and of SPY versus international equities, emerging market equities, and economically sensitive equities, which is a topic for another article) is even more robust over the past 8 years.
Why choose the time frame of 8 years?
2011 marked the beginning of an epic commodity and commodity equity bear market, as global growth came in under expectations, and this investing framework has dominated price action in the financial markets ever since then.
Bond Bulls Licking Their Chops
Despite a rise in longer-term U.S. sovereign bond yields since their middle 2016 lows, bond bulls have been emboldened, as longer-term bonds have been bought on every dip, and the recent price action has bond prices challenging their 2016 levels, as the chart below of TLT shows.
Just looking at the chart of TLT shown above, you would have no idea that the U.S. stock market would be challenging its all-time highs, given the appetite for longer-term sovereign bonds.
Looking Across The Pond Yields Clues
While U.S. Ten-Year Treasury Yields are still materially above their 2016 lows, recently closing with a 2.09% yield versus the 1.37% yield at the 2016 lows, the same cannot be said for German 10-Year Treasury Yields, which have broken their 2016 lows, as the following charts illustrate.
The new low in German 10-Year Treasury Yields has spooked the bond market, as international sovereign bond yields have provided an anchor to U.S. sovereign bond yields.
Additionally, with almost all investors, both individual and institutional investors, believing in lower for longer, which I suppose is natural following an almost 40-year bull market in bonds, there is an air of inevitability that yields will reach ever lower depths, and follow the path of Japan and then Europe into negative territory.
For those that follow that faulty logic, in my opinion, please review a sampling of my public writing on the topic.
- Too Much Worry About Bonds - March 29th, 2019
- Bond Bear Market Still Intact - March 15th, 2019
- The Bond Bubble Is Bursting - Published On October 7th, 2016
Just looking at the above article titles, I am sure strong reactions are being generated in your mind as you read these titles, and again, it has been a comfortable position to be bullish on bonds for a long time; however, investors of all stripes have to keep in mind how far this bond bull market has come over the past nearly 40 years.
Ultimately, for bonds, just like stocks, price matters, and almost all academic research suggests that over 90% of a bond's returns for an investor are attributable to its starting nominal yield (let alone real yields), which is historically low in the U.S. today, and even lower in international markets like Japan and Germany.
Closing Thoughts - Look For A Near-Term Reversal In Bond Yields
With almost everyone leaning bearish on both bonds (and economically sensitive equities too) particularly, look for a violent reversal higher in bond yields (lower bond prices).
The bullish bond trade is an extremely crowded trade right now and bond prices have performed remarkably well over the past decade, given the length of the current economic expansion in the United States.
Looking back, at the start of this expansion, U.S. businesses had ample labor supply, and starting in 2011, commodity prices declined at an accelerated pace too (bottoming in 2016). So if you ran a business in the United States, you had one of the most favorable decades for input costs in history, with scant wage pressures and declining commodity prices, particularly in real terms. For good measure, throw in a stronger U.S. dollar too, which kept a lid on inflationary pressures.
That Golden era for big business in the United States is over, with year-over-year wages rising north of 3%, the unemployment rate at record lows, and commodity prices up materially from their 2016 lows.
Ultimately, all the labor slack and commodity supply slack used up will end the bond bull market.
This already happened, in my opinion, in 2016; however, very few today are aware of this development, as the complacency in the bond market, and the almost complete lack of fear of higher bond yields (lower bond prices), even in the face of rising fiscal deficits, is reminiscent of past bubbles, including the logic that housing prices never fell on a national basis before the 2007-2009 unwind.
Bigger picture, bonds are at a dangerous precipice even compared to the building mania for passive investments, fundamentals still do matter, fundamentals were always the wrong scapegoat, and I still believe 2019 is going to be a banner year for value equities, similar to 2000, as price discovery, after a decade of growth outperforming value, is poised to return with a vengeance.
To close, even though it has been a very difficult, almost decade-long stretch for value-oriented investors, with pockets of significant out-performance, including 2016, I think we are about to enter a golden age for active value investors who do the fundamental work, who can find the future free cash flow-leading companies and the most out-of-favor sectors and the most out-of-favor equities, including this public write-up, who will be at the forefront of this opportunity.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016 and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
Disclosure: I am/we are short TLT VIA PUT OPTIONS AND SHORT SPY AS A HEDGE IN A LONG/SHORT PORTFOLIO. 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: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.