Monday, August 30, 2010

Stock Post on The Daily Capitalist; and Treasury Bonds Have Begun to Bubble

The Daily Capitalist has posted an article I wrote with the very kind assistance of Econophile, the proprietor of said website.

While I discuss in that article why I have begun buying some stocks with the goal of holding them for the long term,the stock market as a whole may well be overpriced and may well prove to be, in the aggregate, poor investments. But such is the nature of investing. Stocks are far from their bubble phase. Perhaps they will enter a sustained period of historical undervaluation. In contrast . . .

The evidence is now that Treasury bonds have entered a bubble and left a standard, mature bull market behind. The economist David Rosenberg is calling for a 2% 30-year Treasury bond. He recently shrugged off the fiscal problems that the U. S. Gov't has, saying that Canada had similar problems in the 1990s. I don't know about Canada's problems, but I would assume, having lived through the 1990s, that no investors were rewarding the federal government of Canada with ultra-low and falling borrowing costs. What is happening in the U. S. is characteristic of bubbles. Those who are short the asset (i. e. have bet against it) are forced, as the price rises enough, to buy it to cover their bets against it, and momentum players jump in who have no interest in the investment merits of the asset. These momentum players are especially dangerous when they leverage their capital many times and thus purchase many more Treasuries than they can truly afford. The combination of short covering and leveraged Treasury purchases are key parts of the development of a bubble in Treasuries.

Another aspect of bubbles is the creation of misguided public enthusiasm late in the game.

In a piece running today, continues the pattern of promoting Treasuries. This piece is given a political wrapper but serves the bubble story well. It is titled Deficit Cost Drop Gives Obama Stimulus Clinton Missed. Here are some quotes from it:

While the government has increased the amount of marketable Treasuries by 70 percent to $8.18 trillion the past two years, rising demand has driven yields so low that interest to service the debt has fallen 17 percent so far in fiscal 2010 ending Sept. 30 from all of 2008.

Instead of punishing the Obama administration for running up a budget deficit the Congressional Budget Office said will total $1.34 trillion this year, bond investors are pouring money into fixed-income assets as inflation slows and equity markets stumble. . .

“The deficit concerns are on the back burner,” said Andy Richman, who oversees $10 billion as a strategist in Palm Beach, Florida for SunTrust Bank’s private wealth management division. “The bigger concerns are on the deflationary mode and seeing growth slowing in the second half of the year.”

Deficit concerns are on the back burner? Really? Perhaps in a parallel universe. Not among anyone I know.

Suddenly, people see the merits of Treasuries at these yields? I doubt it. More likely in my view is that the authorities are trying to scare people enough about the economy that they buy bonds to keep the statist, deficit-finance game going. Will the U. S. actually go Japanese, interest rate-wise? I don't know, but I wouldn't bet big money on it happening.

Here is one example of just how risky long Treasuries are at this level. In July 2007, the 30-year bond traded above 5.25%. Now let's say it is at 3.7% (up from as low as about 3.50% last week). To eliminate reinvestment considerations, I am going to give you the purest type of bond, known as a zero-coupon bond. All the interest accrues to the price of the security rather than coming back to the owner regularly (twice-yearly for Treasuries).

If one purchased a 30-year zero coupon bond at a 3.7% annual yield, the price would be $33.62. This excludes commission. Assume that five years from the now the yield finally gets back to 5.25%. What would this security then be worth? Well, one would now own a 5-year bond yielding 5.25% annually. The price calculates to $27.83 for a bond that will mature at $100 thirty years later.

Even if it took 8 1/2 years for yields to get back to 5.25%, the price of the hypothetical zero coupon bond would still not be back to its starting value of $33.62.

A bond that pays interest semi-annually, which most people are more familiar with, is mathematically similar, though the nature of its pricing and periodic payouts makes it less volatile. Nonetheless, a calculation of this sort of "par" bond would also show how risky a simple reversion to a "normal" yield of 5.25% would be at any time within the next 5 years.

I have begun to tack against the wind. Just as I sold out of stocks almost completely in 2000 and again in 2007, which both times was against the prevailing zeitgeist of growth forever, I am now seeing cash and Treasuries (not stocks) as unduly likely to provide negative returns after accounting for consumer price changes (which I unhappily anticipate to move up and to have more upside than downside risk). I am hearing more stories of people who can welll afford the risk of stocks but who want nothing to do with them, and of brokers who are responding by pushing bonds rather than stocks.

People fleeing into Treasuries because they held stocks too long should know that bonds can disappoint simultaneously with stocks. The idea that people are tying up capital for long periods of time at historically very low interest rates lending to a borrower with no coherent plan to repay its obligations simply because the stock market was vastly overpriced a decade ago strikes me as strange. What a brilliant investment strategy: own a hugely overpriced asset (stocks) in 2000, or simply be afraid of it now when their valuation is much more reasonable, and instead avoid that asset to instead buy another one after it has had an amazing three decade run of outperformance (Treasuries, of course).

The Japan scenario of even lower Treasury rates is a possibility, but not likely here in my view. Time will tell; is there a rush to make that call? One example in a different country proves nothing about the future in America. When it is in government's interest to sell massive amounts of bonds for little more than routine operating expenses (wars in Asia and the Mideast and economic stagnation both having become routine), and the media starts telling you about "rising demand" for bonds at the same time that the Federal Reserve has been a huge part of that demand, caveat emptor.

I now view 7-30 year Treasuries as trading vehicles only, just as I treated Internet stocks back in their bubble heyday. Once again, I am suspicious of situations in which the mainstream media push a story after valuations already are at historical extremes, trying to make the public believe that there is legitimate demand despite the extreme valuations. That to me is part and parcel of the pre-popping phase of a bubble. We are not seeing mainstream media hype for either stocks or precious metals. We saw it in tech stocks in the late '90s and homes 3-5 years ago, and it has begun in Treasury notes and bonds today.

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