Friday, August 14, 2009
Trends Reversing and Implications Thereof
The content on Jesse's Cafe Americain has been informative lately. Not surprisingly, the personal income chart mirrors another one also from www.contraryinvestor.com, on retail sales.
These long downtrends will be in force until they are not. One would at the least expect a snapback, given the extreme nature of the recent declines.
This expected snapback is to a large extent priced into retail stock prices, which now sell with low dividend yields and generally high price to book and price to earnings ratios. Not that the stocks will not rise; I have no idea about Mr. Market's mood or the short or long-term "fundamentals".
Looking back to the left hand side of these charts, one sees that as the years went by, a rising trend of personal income had sharp setbacks. The dominant fear throughout much of that time was literally of a return to the deflationary depression years of the 1930s. A quarter of a century after the worst of the 1932-33 stock and economic cycle is now known to have passed, Benjamin Graham, who mentored Warren Buffett at Columbia and was one of the truly great investors of the 20th century, was able to find numerous NYSE stocks selling for less than cash on hand. This at a time when a multi-year bull market had been in force! It is much easier in hindsight now to have "bought" those dips in income than at the time.
Based on today's data on capacity utilization and industrial production, it would appear that these have hit bottom for the nonce. Paradoxically, the greatest investment opportunity from a risk and reward perspective could be in the major asset class that has performed the worst this year and that one might think suffers from the bottoming of the production cycle: longer term Treasury bonds.
They are both despised and "under-owned" by the public. Even bears such as Robert Prechter advise people to sell stocks and buy ultra-liquid very short-term debt instruments (T-bills), not bonds. Yet a cyclical industrial recovery and an upturn in personal income (or at least a cessation of the decline) means less contra-cyclical government spending, and thus a (relative!) shortage of bonds to a market that has been absorbing unprecedented supply.
Historically, T-bond yields bottom well after a recession/depression ends. The post-Great D low in bond yields was in 1940 or after. The prior 21st Century T-bond low came over a year-and-a-half after the shallow recession ended in 2001. Not that the 30-year T-bond makes sense anywhere the 2.5% it hit last December, but the 10-year is different. It would not be prudent to put all one's money in such a debt instrument given the inflation risks, but consider the following analogy. The great bridge player Marty Bergen says that the bridge point system in which an ace rates 4 points, a king 3 points, a queen two points, etc. underrates the value of the ace.
Similarly, even the fine economists such as David Rosenberg who recommend corporate bonds based on their spread over Treasuries miss the point in their public analysis. U. S. Treasuries are, like it or not, special. All the other bonds must be judged on their absolute yield and riskiness and not on the yield difference over Treasuries.
From a technical basis, the long decline in corporate bond yields has ended. The bull market for Treasury debt remains intact. The CPI is reported to have dropped 2% y-o-y as of July, the sharpest drop since 1950. Thus the instantaneous "real" yield on a 10-year Treasury is 5.5%.
Markets exist in part to surprise the greatest number of people. Can Treasuries (TLT on the NYSE and zero-coupon bonds OTC) truly be vehicles for capital gains as well as safe income?
Time will tell.
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