Equities Will See Short-Term Volatility, But Treasury Yields Make No Sense
- Stocks are likely to see continued volatility over the short and medium term, but are valued more attractively than bonds.
- Current valuations for bonds are historically high compared to the rates on cash and inflation.
- The upcoming bond bear market won't end with a bang, but with a whimper caused by high upfront valuations.
- Inflation isn't that hard to create. I believe the Fed has full credibility in attaining its 2 percent annual inflation target.
- The best moves are to wait for volatility to calm down before buying stocks and to think twice about investing bonds.
What's going on with the markets?
Equities experienced a historical selloff over the last week, with the S&P 500 down 12+ percent. Before, I modeled a 9.25 percent long-run annual expected return for the S&P, which has risen to 10.25 percent after the selloff (9.25 is a little below historical average returns, and 10.25 percent is in line). By the time you read this, the numbers could be higher or lower. I attribute the magnitude of the selloff to a reluctance of buyers of last resort to buy the dip and instead to wait until there's more information on the coronavirus. Historically, high net worth households are the main buyers after bear markets - due to the lower levels of leverage you see in many of those who already have significant wealth, they're able to take advantage of market declines in ways that hedge funds, broker-dealers, and proprietary trading firms often can't. Equity volatility is likely to remain elevated over the next few weeks to months, but over the long run, stocks are far more attractive than bonds.
One interesting piece of the market selloff is that my estimate for the returns of a typical 60/40 portfolio didn't change much over the course of the selloff. This is because the Treasury yields have plunged to near 1 percent per year, taking the entire spectrum of high-quality bonds with it. The price of certainty has risen to the point where after inflation and taxes, you can expect to lose 15-20 percent of your money in real terms over a 10-year period by investing in Treasuries.
Contrary to popular belief, long-run stock returns are not completely mysterious, even if the inputs are constantly changing. Bond yields are even easier to model. The return you get over the life of the bond is the yield in the contract, plus a little bonus from yield curve rolldown if the conditions are right.
Source: A Wealth of Common Sense
I knew when I designed the risk parity strategies in 2018 that whichever way the economy went, the stock and bond positions would balance each other out, with a possibility that they both could win. Now, with yields approaching 1 percent, the situation is reversed, meaning stocks and bonds could both lose. Stocks may fall over the short run, but bonds are now virtually guaranteed to fail to keep up with inflation.
I'm known as a major proponent of risk parity strategies, and the discussion of the theory behind the strategies has circulated among tens of thousands of investors ranging from young professionals to analysts and portfolio managers at hedge funds and family offices.
Below this was the finance theory behind the strategy in 2018 and 2019. Now, with bond yields lower than cash, the line for leverage is not necessarily higher than the line for concentration in equities.
I hate to say it, but the current market environment has broken the math behind a large portion of my risk parity strategies. It's not that the strategies didn't work as intended, because they did, but that they worked so well that valuations have been pushed to the sky, leaving little to no possibility for appreciation over the long run. There are other ways to make money in the public financial markets, but my crown jewel went down the drain - a victim of its own success and popularity. Other stuff still works, like volatility targeting for risk assets, long/short factor investing, and trading against bias/constraints in each asset class, but the Treasury portion of the model is now good as dead at current prices.
Since the Federal reserve began explicitly targeting inflation in 2012, they've done a fairly good job of hitting it, with the official inflation rate for the 2010s at around 1.8 percent annualized. I expect that in the 2020s, especially with the Fed symmetrically targeting inflation to 2 percent rather than tightening when inflation rises above the threshold, that it'll do an even better job of hitting its target. This means the real yield of every maturity of US Treasuries is currently negative. Additionally, the carry (the difference between cash rates and Treasury yields) is negative for most maturities.
In my view, portfolio managers loading up on bonds can expect bad results over the upcoming years.
I can't justify holding Treasury bonds over cash over the long run at current prices. Credit spreads still are fairly tight also, so investment-grade and high-yield corporates are hard to justify. If you're in the top tax bracket, low- to medium-duration municipal bonds can still make sense as a way to earn a little over the rate of inflation without paying tax, but that's about it. Just as the price of certainty was far too expensive during the initial Brexit drama when Treasury yields got down to ~1.3 percent, history is likely to show that bond yields were ridiculous in early 2020. Even if they stay ridiculously low, you won't make much money because valuations are so high.
This point brings me to equities. Cash rates are low and likely to go at least a little lower, and equity valuations are roughly in line with historical valuations in relation to cash rates. This leaves investors with a few choices.
1. Investors with low volatility tolerance may be able to combine cash (or short futures to get synthetic cash positions) and equity positions to get a better return than Treasuries, with increasing dividend cash flow and better tax treatment over time. High net worth investors may combine this strategy with relatively low-duration municipal bonds, depending on valuations. Think of it this way - would you rather have 75 percent cash and 25 percent equities or 100 percent bonds? The first option gives you the opportunity to pick up the pieces if stocks and Treasuries both fall (perhaps because the Treasury has to sell a ton of bonds to meet fiscal stimulus obligations, such as after the 2008 crisis when yields normalized). Cash rates also are higher than Treasury yields at the moment.
It's best to wait until equity volatility (as defined by the VIX going back below 20) and cash rates fall further to do this, but aggressive investors can short cash to buy more stocks, ideally through the futures market. For an introduction to my volatility targeting theory, read this article and this article.
2. No one is forcing you to buy Treasuries at 1 percent yields, and 60/40 is not gospel anymore - if it ever was. If the equity markets fall further and you want to increase your equity allocation, the math will favor you over the long run.
3. If the Fed cuts cash rates to near zero to support manufacturing and consumer spending, then opportunities will be unleashed to make money locally in private equity and real estate. Interest rates are set on a national level, while property markets and businesses are inherently local. This can allow savvy investors to make windfall-like profits over time from changing demographic and economic conditions.
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