Quote of the Week
“And then at the end of the day, the most important thing is how good you are at risk control.
Ninety-percent of any great trader is going to be the risk control.” – Paul Tudor Jones
Wow! What a great way to start the New Year. Last week the Dow was up 2.33%, the S&P 500 was up 2.60%, and the NASDAQ was up 3.38%. The markets opened slightly down today (Monday) but rallied to finish in positive territory.
I recently read an article by Jeremy Grantham that gave a positive outlook on the markets (his opinion) that we could see a near-term melt-up. This reminds me of 1998-1999 where everyone said the markets were overvalued and ready for a pullback. However, the markets continued up even stronger than before.
All economies around the world are in an expansion mode, interest rates are low compared to normal rates, and we just got a tax cut for corporations, which should drive stock prices higher due to increased earnings.
The increased earnings should lead to stock buybacks plus mergers and acquisitions, which should be good for anyone who owns stocks. Moreover, any money repatriated from overseas will also help to drive the stock market higher.
I cannot and will not promise anything, but this sequence of events looks very positive. Of course, as Yogi Berra once said: “Predicting is hard, especially about the future.” We shall see what transpires.
The UPI remains the same at 24 out of 100. Our allocation for most clients remains the same: 85% equities, 0% bonds, 10% alternatives, and 5% cash.
The Bull Market in Bonds is Over
I hope you all remember from Investing 101 that when interest rates rise, bond prices go down.
Bonds have been in a “bull market” for the past thirty-seven years. Bond yields have fallen consistently since Paul Volcker ended the inflation of the 1970s. I can remember where I was when you could buy a 30 year U.S. Treasury Bond at 15.2%. That means you could have locked in an income of $15,200.00 per year on a $100,000.00 investment for 30 years and then received back your original investment. The year was 1982. However, no one would buy them because you could get 21% in a Money Market. What interest can you get now in a Money Market?
Just like any long-term bull market values get out of whack. The current 10yr Treasury yield is 2.50% which equates to a 40.9 price-earnings multiple. That is a higher price-earnings multiple than the stock market at its height of the Tech boom in March of 2000.
However, the bond market has become the “knower of all things.” It is never wrong according to the bond bulls. Low yields are not only justified; they tell us the future.
There are three main bullish arguments for the bond market.
- The U.S. faces secular stagnation meaning permanently low growth and low inflation.
- Foreign yields are lower than U.S. yields, so market arbitrage will keep U.S. yield from rising.
- The Fed is raising short-term rates, which will cause the yield curve to invert, leading to recession and lower yields over time.
But there are serious issues with all these arguments. First, it is not true the bond market is never wrong. In 1972, the 10yr U.S. Treasury yield averaged 6.2%, but inflation averaged 8.7% between 1972 and 1982. In 1981, the U.S. Treasury yield averaged 13.9%, but inflation averaged just 4.1% between 1981 and 1991. In other words, the bond market underestimated inflation in the1970s and severely overestimated inflation in the 1980s.
The main reason was that the Fed artificially held down short-term interest rates in the 1970s, which pulled the entire yield curve too low. Then, in the 1980s, it did the reverse and held short-term interest rates artificially too high.
The past nine years are similar to the 1970s. The Fed has pulled the entire yield curve down, while big government (taxes and spending) have held growth back. Now, growth and inflation are picking up, while the Fed lifts short-term rates. Just like in the 1980s, tax cuts, regulatory rollback, and contained government spending will disprove secular stagnation. Fed tightening will push the yield curve up, and bond yields will rise.
The low foreign bond yield story does not hold much water. Japanese bond yields have been near zero for at least two decades. If International arbitrage works to bring rates together, why aren’t U.S. yields near zero or why didn’t the Japanese bond yields move higher. It seems as though 20 years would be enough time for the yields to adjust. It comes down to fundamentals.
Every country has different growth rates, different currencies and inflation, different trade flows, credit ratings, tax rates, and banking rules. Every country is unique so bond yields will not be the same.
This year the Fed is on track to ratchet the federal funds rate higher in three, possibly four, quarter-point moves. With real GDP growth picking up to roughly 3% and inflation moving toward 2.5%, or higher, nominal GDP will grow at roughly a 5.5% rate. That is the fastest top-line growth the U.S. has experienced since 2006. Moreover, in 2006 the 10yr Treasury yield averaged 4.8%
I do not know if yields will head back to 4.8% anytime soon. However, the risk is to the upside on bond yields, not to the downside. The bullish case for bonds has finally run out of steam.
By the Numbers
OFF JUST A BIT – In January 2007, the Congressional Budget Office forecasted a$249 billion surplus in fiscal year 2017 (i.e., $4.284 trillion of tax receipts less $4.034 trillion of outlays). Fiscal year 2017 actually produced $3.315 trillion of tax receipts less $3.981 trillion of outlays, a$666 billion deficit (source: CBO). Michael A. Higley, BTN 01-08-2018
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These are the opinions of Larry Lof and Stephanie Mayoral and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Past performance is not indicative of future results. Due to our compliance review process, delayed dissemination of this commentary occurs. The S&P 500 is an index of stocks compiled by Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Indices mentioned are unmanaged and cannot be invested into directly. Technical analysis represents an observation of past performance and trend, and past performance and trend are no guarantee of future performance, price, or trend. The price movements within capital markets cannot be guaranteed and always remain uncertain. The allocation discussed herein is not designed based on the individual needs of any one specific client or investor. In other words, it is not a customized strategy designed on the specific financial circumstances of the client. Please consult an advisor to discuss your individual situation before making any investments decision. Investing in securities involves risk of loss. Further, depending on the different types of investments, there may be varying degrees of risk including loss of original principal.