Monday, November 8, 2010

Two Contrarian Reasons to be Bullish on the Long Bond

Based on certain precedents, we may just have top-ticked the long bond, or may be within months of a top to be followed by a major drop in long rates.
(See the accompanying long-term chart of the reintroduced 30-year bond from the late 1970s to present; click on chart to enlarge.)

As of Friday's close, the spread between the 2-year bond (note) and the 30-year bond's yields were about equal to the post-1980 highs seen in November 1992, November 2003 and midyear 2009. These three times all afforded both good short-intermediate trading opportunities as well as good total returns on a 1-2 year time frame.

The first two of these occurred when the fear of price inflation had been stoked by Fed easiness post-recession. Interestingly, last year's peak spread occurred more or less exactly at the trough of business activity when there was great anxiety about the inflationary activities of all the various Fed and Democratic interventions.

Interest rates are related to business confidence. When business confidence is low and the profit picture is poor, it is likely that this mood will be reflected in low bonds yields and not high stock prices. Thus it is a very interesting fact (factoid?) that Bloomberg reports that earnings estimates by stock analysts ("analysts" is my point of view) have just set a survey record. From the article:

About 1.5 U.S. companies boosted earnings estimates above analysts’ forecasts for each that cut projections in October. That’s about three times the average of 0.59 in the past 10 years, data tracked by Bloomberg show. The ratio fell to a record low of 0.1 in December 2008, three months after New York- based Lehman Brothers Holdings Inc. filed for bankruptcy. When it reached 1.1 in March 2004, the S&P 500 rose from 1,126.21 to a record 1,565.15 in October 2007, Bloomberg data show.

(Presumably March 2004's ratio of 1.1 was the prior record.)

Long interest rates continued upwards for a few months after that March 2004 record, but to conservation at the Fed and probably in the popular mind, there was a "conundrum" as the Fed began raising the Fed funds rate in June 2004 in response to optimism on the economy. The yield on the long bond started falling and in a year or so from the start of the modest rate-raising cycle, fell to about 4.25% from about 5% at the end of March 2004.

The Bloomberg article happens to precisely delineate the precise wrong time to hold the long bond: when businesses are very gloomy and there has been a flight to "safety" in Treasuries. It was in December 2008, when there were pictures of Depression-era soup lines in the popular media and virtually all profit estimates were being downgraded, that the long bond's yield briefly went under 2.6%. Time to not be an owner; and on more than a few month's perspective, a great time to buy stocks. The stock market averages are up about as much since December 2008 to now as in the 3 1/2 years following a lesser degree of up/down earnings revisions seen in March 2004.

When optimism among businessmen is the order of the day per the Bloomberg article and fears that the Fed is buying way to easy as judged by the 2/30 yield ratio addressed at the start of this post, one way to be a bit of a contrarian is to buy a long-term Treasury bond (or bond fund) with the intent of selling it for a capital gain plus the interest payment that far exceeds returns available to cash.

I buy "off-the-run" rather than on-the-run Treasuries. Where appropriate, such as in an IRA, I also buy zero-coupon Treasuries rather than par bonds because of the combination of higher yields and greater capital gain potential should rates drop (of course, there is equally greater potential for loss if rates rise, but my game plan in that case is to be patient and not to sell at a loss).

A review of the chart above shows about a 3-decade bull market in Treasury bond prices; that is, steadily declining yields. Bulls on the stock market cannot point to a 3-decade-long secular bull market in stocks. Meanwhile, with rates everywhere from rates on cash to the 5-year bond at all-time record lows, and the 3-month T-bill exactly equal to that of Japan, who is to say that the record of a 36-year secular bull market in bonds will not be met or exceeded?
Because of its duration, in a way the yield on the long bond is a sentiment-driven instrument in some ways similar to the influences on speculative, unprofitable stocks. No one knows the future; place your bets. Recent history suggests that when it looks as though the business cycle is going to turn sharply as reflected by very high yield differentials between short-term and long-term Treasury yields, the contrarian buyer of the long bond has had good trading opportunities in a reasonable time frame or of course has been able to hold the bond and reap the income plus own an appreciating asset.
Nothing herein constitutes investment advice, and as in other posts on this subject, I would emphasize that the long-term Treasury represents a somewhat speculative investment in my view. I use it as a balancer within the portfolio as Treasury yields tend to bottom (and thus bond prices top) when stocks and perhaps precious metals have had significant drops.
Copyright (C) Long Lake LLC 2010

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