Thursday, January 28, 2010

Treasuries vs. All the Others

Mish has a post upon which I would like to expand, titled State of Wisconsin Goes Insane With Leverage; Corporate Bond Mad Rush Is On.

Please read it with an eye toward the charts.

Note that the California municipal bond ETF (symbol CXA) has outperformed the Treasury bond market in price appreciation over the last 2 years. Shown here is the ETF for the long Treasury bond; the equivalent for the intermediate bond, IEF, has a very similar 5-year chart pattern. This seems a bit backward. California can only print scrip; Treasuries can do what Japan has done for years in the context of a bull market in its Government debt and print unlimited amounts of it.

Other bond funds have surged to all-time record price highs (low in yield).

Mish makes the point that there is an overabundance of enthusiasm for these bonds. On an absolute return basis, the lowest investment grade bond, the Moody's Baa corporate bond, is trading around its multi-decade low in yield, just over 6%, about as low as its yield got at the most frenzied part of the recent credit bubble.

Consistent with the observation that too much money is chasing these subpar credits, others have reported that the amount of money flowing into bond funds is at bubble levels: 3 standard deviations above the mean (excuse me for not having the precise reference handy).

Compared to all this, Treasuries look like the only bond one wants to own if one wants to own bonds. (Or, foreign sovereigns but be careful of overpriced Mexican, Indonesian and Russian sovereign debt.) At least the Feds can both print money and tax the corporations. Meanwhile, measures of economic activity remain at levels of several years ago, so much growth must occur just to get back to prior peak (2008) levels of economic activity. While most of us hope for good things, it would appear that the public is late to the bond party.

All this makes the sloppy behavior of gold and Treasuries more understandable.

Now that the Fed has proclaimed "recovery", I am reminded of Alan Greenspan's quip of about 10 years ago that just because the Fed, with the greatest number of economists in the world, had an incorrect quarterly economic forecast for (say) the last 16 quarters, there was no reason not to think that it might just be correct the 17th quarter.

If you want to own corporate bonds or munis, please at these prices own the bonds directly. An ETF or mutual fund is perpetual. There is no expiration date. It is possible for you to receive a 5% interest yield every year but the market price (net asset value) of the ETF or fund to decline 7% yearly, simply as a consequence of rising rates even with no defaults in the portfolio. At least when you own the bond directly, it pays off at maturity and even if you regret buying at a 5% yield when rates go quickly to 8%, at least you get your 5% assuming no default.

There are structural bull markets currently off their peaks but no bubbles in gold, Treasuries, and a variety of individual stocks, almost all of them high quality. Meanwhile individual stock issues keep blowing up, the latest being the high-quality one Qualcomm. High-P/E stocks such as QCOM are problematic. I would much rather own the common stock of Ross Stores (ROST) at about an 8% free cash flow earnings yield than its debt, given that Ross is trading at about 12 times estimated year-ahead earnings. Similarly, the highly secure Chubb (CB) is trading at about 9 times estimated earnings, a 3% dividend yield, and a much higher free cash flow yield.

The larger point I am making is that some markets have moved out of proportion to the known changes in the real economy. There is finally the opportunity for commonsensical analysis to beat the market, simply by avoiding the above-mentioned California muni fund CXA and other risky bond funds and sticking to relatively undervalued quality.

For new readers, though, please understand that in this blogger's humble opinion, virtually all financial assets are overvalued relative to labor's wage rates. The overgrowth of the finanical markets is the largest disequilibrium out there, and threatens our society with more chaos more quickly than climate change or Iran's possible nuclear arsenal.

What are our leaders doing about it?

Fighting to grant health insurers the mandate to collect feeds from every American (party in power), thus further increasing the power of the financial interests; and the two parties are engaged in tastes great/less filling argument over whether to increase the Federal deficit via more spending (party in power) or via fewer taxes (wannabe in power party).

The American people are in front of their elected officials. Will another Ross Perot emerge?

Until then, it's hard to see gold entering a secular bear market, periods of price weakness notwithstanding. As far as Treasuries, they could rally hard on a flight to safety or on an economic boom in which issuance declines drastically.

Time will tell.

Copyright (C) Long Lake LLC 2010

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