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

Financials Under Stress

It's a bit pat to look at a sell-the-news down-move in stocks following what might be a major-league blowout election for the Repub side of the Republicrat/Demopublican Party and then the Fed meeting with potential friendly moves for financial assets, but more immediate adverse things are happening. A former blue-chip trust bank, Wilmington Trust (WL), more or less bit the dust today. It is of concern as a possible canary-coal-mine sign of lots more undisclosed problems with the asset base of other financial companies.

The details are a tad disturbing. The company announced quarterly results today, which revealed massive losses in its commercial real estate portfolio. Book value collapsed. The stock, which was $20 in the past year, is now at tangible book value under $4.

Simultaneously, an acquirer was found. This was not just any old acquirer. It was M&T Bank (MTB), which is 4.5% owned by Warren Buffett's Berkshire Hathaway (symbol BHK-A or BHK-B; BH for now). BH was a major beneficiary of the 2008 financial crisis, helping to bail out Goldman Sachs on much more favorable terms than the administration negotiated on behalf of the taxpayer. I suspect this was a political deal to quietly hand M&T to BH. Whether this was a favor owed by BH to Treasury and therefore was done above market value, or whether this was another gift to BH, or neither, cannot be known by yours truly.

Wilmington Trust has now collapsed below its bear market low. This is serious and so far as I know comes out of the proverbial nowhere. You may have noticed that Ambac is near bankruptcy as well, news that also broke today. The ticker symbol for Ambac is ABK. It might as well be BK!

Meanwhile, milder problems surfaced in the financial world. JPM is being scrutinized by the SEC regarding a mortgage securitization. The venerable Metlife has disclosed irregularities in its mortgage servicing division, and the division of Goldman Sachs that is a large mortgage servicer is on a credit downgrade watch.

Meanwhile, some measures of optimism about the stock market have reached very high levels just as insider selling has also reached extremes.

All this occurs as the 2-year Treasury yield is mired at new lows not only for this cycle but since the Great Depression at a Japanese-like 0.34%. I am told that this is more or less a free-market rate rather than one imposed by the Fed. Thus some very smart, large and serious money is leaving a lot of income on the table by hiding in 2-year Treasuries rather than buying the Dow at a much higher yield. Thus this vast pool of money at the very short end of the curve is implicitly saying that stocks are seriously overvalued, and that the dividend payout will largely be offset by price declines.

If one were to overlay the 5-year price charts of BofA (BAC), WL, and ABK, one might be interested to note that they have the same pattern as the chart of the 10-year bond.

When I discuss these matters with my financial professionals and the "investor on the street", the overwhelming consensus is that it the very long term Treasury bond is the riskiest and worst investment around. People are accepting gold more than the long bond.

What may well happen is that with WL stock collapsing overnight, it is clear that tangible book value in financial companies is meaningless. Thus there is no solidity to any banking company's valuation. All are suspect. We know that Citi was a goner in 2008 if not for the taxpayer, and BofA was close. The failure of the housing and commercial real estate markets to rebound mean that the real estate depression and the vast amount of securities tied to it looks to be acting as an undertow against the natural tide of economic expansion in a country with a growing population.

One has to be patient with macro events. ABK helped touch off the financial crisis in late 2007, when it and other similar companies were found to have insured garbage securitizations. Yet only three years later does it look to be dying.

GM was dying for years, but the final stock collapse came rapidly.

Ripeness may be all, but when will the fruit fall from the tree and then start rotting?

Dunno, but with regard to my contrarian speculative position in long Treasuries, I did see a headline I liked today on Yahoo's Finance section. It was the banner headline by the stock summary. It said something like: "End of the 30-year bond rally".

That might be like ringing a bell at the end of a move. The 30-year bottomed in yield in 2003, at the bottom of the short and long term interest cycle, at 4.10%. Sixteen or so months past the (alleged) end of the recession, it would fit my sense of symmetry if the yield, now at 4.02%, respected that 4.10% level as important resistance.

About a year ago, when long-term rates were much higher than now but ZIRP was well ensconced, I bought long bonds and commented to the broker to the effect that the Government wanted to run large deficits and would probably-- somehow-- engineer lower rates to help pay for them. Without knowing how, please look at this chart of the 30-year Treasury bond since inception in the late 1970s. Is it not possible that there has been an invisible hand leading the yield lower?

The current yield is seen to be around the downtrend line one's mind's eye can draw starting around 1981. (Click on the chart to enlarge.)

And with the 2-year Treasury having joined the 1-year note as well as the yet shorter-duration T-bill market at new lows for the cycle and showing no current signs of upward pressure, the outlier is the much smaller and volatile long bond market. Thus sentiment can change rapidly, because while we think we know the price changes coming down the pike the next few months, what happens years from now is pure conjecture.

All we need is one mini-crisis in the banking sector to drive yields a lot lower in the 10-30 year range; or, serious buying of the long bond by the Fed. Who knows, but the downside of holding said bonds to maturity is not the end of world unless the financial world actually ends via hyperinflation; and to that possibility I say: got gold? The upside of being correct on a bond purchase for a trade is however significant even if one simply has to metaphorically clip coupons for a year or five.

Copyright (C) Long Lake LLC 2010

The Trend Is Your Friend Till It Ends: Application to the Long Treasury Bond

The nearby chart shows the yield on the long (30 year duration) U. S. Treasury bond since it was instituted in the late 1970s. I have visually estimated the rate of decline of the yield since the early 1980s. At the least there has been a 3% decline per year.

(Taking a 13% yield in 1982 as the starting point from which to estimate a trend line provides a decline in yields of over 4% per year, so the numbers provided below are conservative.)

To clarify my terms, a 3% decline from a 10% yield would be a decline to 9.7%. A 3% decline from a 4% yield would be to 3.88%. In other words, I am estimating that from year to the next, the yield on the long bond drops to 97% of the prior year's yield.

Currently the yield is 3.82%.

The current bond rally began in 1981. Bond historians say that 36 years is the longest duration of a bond rally in U. S. history. Given record high yields in 1981 and record low short-term yields today, I am projecting for discussion purposes that the drop in rates continues for 5 more years at a straight 3% drop in rates yearly.

If this occurs and the yield curve remains moderately upsloping, the buyer of a 30-year bond tomorrow will in 5 years own a 25 year bond which may itself then yield 3.0%.

If that occurs, the annualized return to the purchaser of a zero-coupon 30-year T-bond would be 8.2%.

This discussion is of course theoretical. It ignores transaction costs, taxes and the like.

But it does show that the most liquid, non-callable way to bet on a decline in long-term interest rates while locking in a positive nominal return on capital can easily give stock-like returns.

All the same considerations apply to standard "par" bonds that pay interest, just "less so".

Copyright (C) Long Lake LLC 2010

Why Short Duration Treasuries Are Overvalued but Long-Term Treasuries May Be a "Buy"

Just as it can be more properly argued that it is a market of stocks rather than a stock market, certain parts of the bond market can be bubbly and others be reasonable buys. An obvious example came in the wake of the Lehman-AIG market disruption, where the 30-year Treasury yield collapsed to 2.6% just as yields on sub-investment grade bonds soared. Anyone who invested bravely in the asset with the depressed price (high yield) did much better than anyone who bought Treasuries at their high prices (low yields).

This piece will present the case for investing in long-term Treasuries while at the same time believing that the 5-year and under space is significantly overpriced and therefore bubble-like in valuation.

A stock analogy to this argument came in the late 1990s. The average NYSE stock actually peaked in 1997-8, but the DJIA peaked at the end of 1999, the NASDAQ in March 2000 and the S&P 500 later in 2000. Yet many stocks bottomed in March 2000, such as homebuilders and many industrial companies. It was as if people ran from the port (tech) side of the ship to the starboard (anti-tech) side of the stock ship at the same time.


It appears that a milder version of that phenomenon could be set up to happen in bond-land.


Before reading on, you may wish to look at the nearby long-term chart of interest rates in Japan.
(Click on chart to enlarge.) I will refer to it later.


Please also consider an excerpt from a blog from 2005 by the then not-so-well-known blogger Calculated Risk, in which he commented on then-Chairman Greenspan's "conundrum" speech regarding the failure of long Treasury rates to increase as much as expected as the Fed engaged on its tightening regimen:

But I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.

By the way, here is CR's below-consensus view nowadays:

I expected a sluggish recovery in 2010, so I thought the unemployment rate would stay elevated throughout 2010 (that was correct).

Going forward, I think the recovery will stay sluggish and choppy for some time and I'd guess the unemployment rate will tick up in the short term and still be above 9% later next year.

I more or less agree with CR though I may be a bit more bearish than he.

So the predicate for the following discussion is the view that while economic jiggles upward are to be expected, too many data points simply point to a general stagnant trend for the pace of business in this country for me to argue against accepting that stagnant trend as the New Normal.

Despite that New Normal and the fact that 0.5% interest rates on 3-year money are crisis lows and reflect a poor state of business affairs, let's consider how extreme the market's estimation of fair value for interest rates in the "out years" has become. As first Mr. Greenspan and then Dr. Bernanke led the Fed's long slow interest rate-raising campaign, the "conundrum" of a flattening yield curve caught their eye. At the interest rate peak in mid-2007, more or less all rates from 1 day to 30 years were identical at around 5.25%.


For historical purposes, please be aware that through much of the 1800s, short-term interest rates were generally higher than long-term rates. This reflected such factors as productivity gains, generally under a gold or bimetallic monetary system. As the Japanese experience the past decade reflects, though, prices may fail to rise even under a non-metal-based (i.e. "fiat") monetary system.

What is the message of Mr. Bond today?

Well, the 2-year bond is at 0.35% yearly, the 3-year at 0.52% and the 5-year at 1.10%. Using a simplified model of implied bond yields farther out the curve, one can calculate as follows.

The 30-year Treasury bond yields 3.75% each year for 30 years. Thus a $100 investment in this bond at "par" of $100 per bond provides a gross total of $112.50 in interest payments over 30 years.

If one were instead to purchase a 3-year Treasury note, one would receive about $1.50 gross over 3 years for every $100 invested (lent to the government), or a "grand" total of $4.50 over the 3 years. It hardly seems worth bothering (especially when credit card companies that have bank subsidiaries are offering FDIC-insured yields of 1.3-1.5% even today). Subtracting interest income over 3 years from that obtainable for 30 years gives income attributable to years 4-30, In those final 27 years, one would receive $111, spread evenly over each year. This computes to about 4.1% yearly.

Turning to a comparison of the first 5 years of the yield curve vs. the final 25 of a 30 year stretch, under current rates one accepts 1.1% a year for 5 years. Similar math to the above would imply a 4.28% yield yearly for the terminal 25 years.

Let's look at matters differently. To choose 5 year paper over 30 year has one certainty. At the end of 5 years, the investor of $100 in a 5-year note will have earned $5.50. He/she will have $105.50. The investor in the 30-year bond will have earned almost $18, or about $12 more. The first investor will be more than $12 behind the proverbial eight-ball (to mix a numerical metaphor). It will not be so easy to find the right investment for the next 25 years just to come out even with the buy-and-hold investor in the 30-year bond.


The numbers get more interesting as we go farther out on the curve. If the 20-year Treasury yields 3.2% today, then it pays $64 in interest per $100 over that 20 years. Subtracting that from the total payout to the 30-year holder implies an average yield for years 21-30 (the final 10 years of the 30-year bond) of 5.1%.

Voila! We are nearing the rates extant in 2007.

A back-of-the-envelope guesstimate is that the bond market is implying a 5.5% yield is proper for year 30 on its own.

In other words, the long bond is in no bubble whatsoever. It is the low-yielding front years that are wildly overvalued (under-yielding).


Well, all this guessing about the "right" interest rate in the out years is absolute conjecture on the part of the bond market. The truth is that the bond market has little more idea than you or I what economic conditions will be like a year or two from now, much less many years out. Japan scenario? Greece (though with a printing press)? U. S. 1970s, with bear markets for both stocks and bonds? Everything good?


The truth is that we really don't know what will happen from one day to the next. One summer day several years ago, I left home and about 10 minutes later walked into the doctors' lounge to grab some coffee before seeing my hospital patients. The TV showed that an accident had occurred in downtown New York; an airplane had just hit one of the World Trade Centers. Since that time, the Fed has almost never voluntarily pushed the Fed funds rate above CPI, in contrast to its policy of most of the prior 2 decades; and the U. S. has been on a semi-war footing even despite the election of a "peace" candidate in 2008.



The world changed during my brief commute to work. Two-three years from now could be another eternity, just as the past few years has been.

The current trend is the Japanese one. Zero interest rate policy ("ZIRP") is resorted to as an emergency measure by the central bank. The acute emergency ends, but chronic illness emerges. Zero or near-zero interest rates continue to anchor longer and longer maturities toward zero. Meanwhile, market participants continue to rationally expect a reversion to the interest rate mean. This has been the Japanese experience, and to date nothing other than hope for better times has occurred in the U. S. to differentiate us from them.


Let us look again at the chart of interest rates in Japan. After the yield on the 5-year note fell to new lows in 2001-3, the 30-year actually fell more in yield than the 10-year. Whenever the yield gap, in absolute and percentage terms, was wide, it paid to buy the 30 year.

Why should it be different here and now? Because we have nukes and they don't?



In addition, there is a specific potential catalyst for outperformance of the long bond. That is the expected "QE2", or further expansion of the Fed's balance sheet, a/k/a yet more money-printing, with the now unconcealed primary purpose (per the NY Fed's executives in recent speech(es)) of keeping financial asset prices above fair value. (In other words, trickle-down economics . . .)


It is known that the public has been rebalancing its portfolio from stocks toward bonds, but the bonds it has been buying are almost entirely short-to-intermediate term securities, or so it has been reported. Thirty years ago, bonds were known as certificates of confiscation. In my humble opinion, that's likely what 5-year notes are today. Apparently the public is nervous about the long term future for interest rates and is so nervous it is moving heavily toward the short end. Where the public is nervous, it's usually a good idea to think about being a contrarian.

Getting back to the potential catalyst for a rapid and large drop in long-term rates, what if Dr. Bernanke took a quick look at the interest rate curve, saw the record or near-record absolute and relative spread between the 2-year and the 30-year bond, and between the 10-year and the 30-year bond, and said the following any time in the near future?


"The yield curve is too steep. The Fed is going to target the 10-year yield at modestly below its current level but believes that a more appropriate level for the 30-year bond is at most 3%, which provides a positive return after targeted inflation of 2% with utmost security of principal and is thus a yield that is fair to both the lender and to the Treasury."

There would be a rush to the long bond, of course. Now here is where the arithmetic gets interesting. A drop in interest rates of 75 basis points on a zero coupon bond for a 30-year security from 4% to 3.25% (rates on zeros are higher than rates on par bonds that pay interest) gives a price change of the zero coupon security from $30.80 to $38.30; quite a percentage move.


Let us take the Japanese experience. If 5 years from now, a zero coupon security purchased yielding 4% turns into a bond (at that time a 25-year bond) yielding 2.5%, the price will be $54 (from $30.80, to remind you).


If at any time within those 5 years the yield drops that much, the annualized return will be greater, even if the price is less than $54.


Aside from Fed action, why might the long Treasury be a fundamentally attractive investment for individuals, especially for tax-deferred accounts such as IRAs?

Might the U. S. actually "walk the walk" of fiscal prudence? Might the authorities, after all the fruitless manipulation of monetary aggregates, get back to where they once belonged and accept the obvious principle that aiming for price increases is harmful to the people they are supposed to serve, and primarily only benefits the financial class?


Might some form of hard money serve as the chosen solution to ratify most of the unsupportable promises known as debt and social obligations the Feds have willing taken on?

Might the government actually go to a peace economy?


In any case, back to supply and demand, and to fundamentals of return adjusted for changes in the general price level ("real" return). Here is a link to a Morgan Stanley estimate of outstanding Treasuries by duration. There are not a lot of long-duration Treasuries. The yield spread is large. A buyer of a 5-year Treasury at 1.1% could get creamed simply by an average of 3.5% price inflation per year, whereas the buyer of the long Treasury would (pre-tax) be holding even and the buyer of the zero coupon bond would be accruing perhaps, after all is said and done, a small positive return yearly.


Thus, in conclusion, there are potential capital gains that might accrue soon to the purchaser of long-term Treasury bonds, with said possible gains being leveraged via purchase of zero-coupon instruments; and there is greater protection from inflation over the next few years by purchases of those types of bonds rather than the short-intermediate duration vehicles to which J. and J. Q. Public have reportedly been flocking.



Some caveats:


1. Anyone reading this who is not a regular reader of my posts would not be aware that I have spent weeks and many months criticizing the monetary authorities for unfair and inappropriate printing of mass quantities of money. I have published a series of on-line articles describing various ways in which I have been investing significant portions of my financial assets to try to protect them from the ravages of all this money-printing; principal among them is gold (I have blogged favorably about gold since winter-spring of last year). Here is a link to the first of that series, on September 8

2. For taxable accounts, well-chosen tax-exempt municipal bonds may provide the optimal risk-reward for buy-and-hold bond investors rather than Treasuries. This discussion of Treasuries unfortunately is in the context of my post titled We Are All Speculators Now, from September 20.


3. Investing is risky, speculating is risky, and purchase of long-term bonds entails a commitment to, well, the long term, even if a profitable sale of the bond is hoped for in the shorter term. The potential for gain entails meaningful potential for loss, especially adjusted for possible sustained rapid rises in living costs.


4. Nothing herein or in any of my on-line posts should be construed as investment advice to any person, as opposed to simple commentary and conjecture. Reasonable efforts have been made to present economic and numerical data as accurately as possible, but please take nothing for granted and do your own math and research as appropriate to your level of interest.

Copyright (C) Long Lake LLC 2010

Trading Uncle Sam's Debt for Burgers and Fries

The long Treasury bond has defied the obvious tendency that when a lot more of something is produced, the price tends to drop. Instead, there has been a buying surge in Treasuries. Thus, based on such reasons as weakening forward-looking economic statistics, general disdain for the way in which the economy has been run (including disapproval that it is being "run" at all rather than functioning freely), and the technical picture just a few weeks ago, I turned tactically bullish on bond prices just a few weeks ago, as discussed in various blog posts.

The Treasury markets have moved massively in a very short time, with relatively little fundamental support for such a large repricing. The 10-year (not shown here) has collapsed from high to low in 4 1/2 months over 35% in yield (4.0% to below 2.6% briefly). The 30-year (click on image to enlarge) shown here has moved less, and I favor it over the 10-year as the yield spread between the 10 and the 30 hit over 120 basis points and compressed today to a very wide level of 110 bps.

Nonetheless, the absolute yield level of the 30 year bond at about 3.7% is at or below the lowest level its 200 day smooth moving average hit during the entire 2008-9 stock bear market and amazing Treasury bull market. Thus I'm thinking there's some combination of fundamental and technical overvaluation here in both the 10 and 30 year bonds, with greater risk in the former (and less reward).

Who knows, but it's looking more and more to me that a base case is for the 10-year to correct upward in yield even if the longer-term picture is for a 2% yield and a 30-year yielding in the 2.5-3.5% range. Thus the long bond, which day-to-day tends to trade directionally with the 10-year, is in my view a difficult hold from a trading perspective, and I have taken some nice profits for a 1-2 week trade. A completely unscientific rule of thumb I have developed is that if I can "make" one year's worth of interest income from a quick bond trade, I strongly consider taking it. If I get two year's worth of interest income, I grab it.

Thus I've reversed most of my bond purchases put on in the last few weeks.

Meanwhile, one of the many correlations I have found useful in the post-Great/Global Financial Crisis world is that MCD (McDonald's; Mickey D) has for over a year traded in line with the 10-year. MCD recently joined gold in making a new all-time high in 2010; I believe MCD is the only Dow 30 Industrial to do so. And this is MCD's 2nd surge this year to a new high, if memory serves me well. Meanwhile, with the amazing fall in the 10-year yield to well under 2.70, MCD yields 3.00% now and thus can easily appreciate 10% in price and still be fairly valued under this relationship.

In addition, should the rest of this year not have a re-run of 2008 or worse, MCD's board will increase its dividend late this year for 2011. My guess is about a 9% increase. Thus I reason that if the 10-year yield is at 3.0% sometime next year, MCD stock could easily trade at that same 3.% dividend yield it now enjoys and thus stockholders could see a price increase of about 9% to keep the new (projected) yield at 3.0%, plus the current yield of 3.0%, and thus get a total return of 12%.

If over the next 10 years MCD's dividend rises at a compound annual rate of 7%, it will have a terminal dividend yield of 6%. Thus for every $100 invested in the stock at today's price, about $45 would come back to shareholders; this is vs. about $26 back to buyers of the 10-year bond at this week's price/yield. All other things being equal, MCD's stock price could thus drop 19% (45-26) ten years from now and be about an equally good investment as the 10 year bond.

This August 18, with so much of the public convinced that the "Great Recession" never ended and thus pinching pennies, and with MCD's sales and profits growing in the U. S. and abroad at a pretty good clip, a good part of my personal trading money has abruptly shifted to MCD on the early breakout to new highs and sold the extended Treasury move. If MCD stock price falls without a change in the fundamentals and without a massive breakdown in Treasury prices, I plan to buy more.

Less than 10 years ago, the stock market recognized McDonald's as a poorly run behemoth. It cleaned up its act. Will the U. S. government, another poorly run behemoth than unlike McDonald's is a monopolist extraordinaire, do the same?

Copyright (C) Long Lake LLC 2010

Treasury Bull May Be Recrudescent

In the accompanying 2-year graph of the price of the ETF that tracks the price of the long Treasury bond (TLT) and thus moves inversely to interest rates, the red line shows the 200 day and the green line shows the 50 day smoothed moving average.

Shorter time frames show that the 200 day sma is actually pointing upward, and thus has reversed its downtrend that began last spring.

The general pattern is one of a modest uptrend in the TLT price. The recent breakout is steeper/stronger than any since the post-Lehman wild surge up in price. This move up in price reflects the bull market downward in interest rates on Treasuries that has been in force since Volcker eased for good in 1982.

Unless we see a quick major surge in rates, we are going to see a golden cross soon on this and on the equivalent ETF that closely tracks the 10-year note (IEF). That this golden cross would occur with an upsloping 200 day sma strikes me as bullish (for bonds).

Today's action is interesting. Stock averages are up but Treasury rates are flat to marginally down on the 10- and 30-year. Thus the reflexive moves in divergent directions that characterized the 2009 stock rally off the bottom may be ending. Cumberland Advisors is positing that the financial troubles in Europe will help keep rates low here and thus act as a growth stimulus here.

I'm skeptical of that viewpoint. If all the passengers on a ship that is taking on water rush to one side of the ship, it is true that the other side of the ship will rise farther off the water. But it's all one ship. To really accept that view, I'd have to see a situation a la the 1997-8 financial crisis, where it was all about "over there", the U. S. was booming and benefitted from importing the deflation in the troubled countries, and not the current situation where the troubles began here.
So what if scared money rushes here? It would appear to be too little, too late.

A few months ago, this blog offered a suggestion that Treasury rates were peaking. Investors who bought and hold then received income and now have unrealized capital gains. For whatever reasons, the charts and capital flows suggest lower yields ahead in the 10 year and 30 year U. S. Treasury bonds. If this occurs, will this be the last gasp for this wheezing bull market? Sure, but I believe that the longest interest rate bull market in the U. S. lasted 36 years. We are at 28. And given that we are at record lows on the short end, who is to say that we don't have at least another 8 years to go on this bull?

It may make absolutely no sense, but markets are often designed (or just happen to come to be structured) to fool the greatest number of the public so that insiders can be properly positioned for the big moves.

Copyright (C) Long Lake LLC 2010

The Case for, and against, a Trade in Treasuries

Structurally, one can see from the accompanying 5-year chart of TLT (an ETF for the 20-30 year T-bond) closing yesterday at 89.80, it is at one level of multi-year support. Even during the commodities-fueled inflation of the first half of 2008, when oil crossed $140/barrel and gold first passed $1000/ounce, TLT traded in the 90s.

(Click on chart to enlarge.)

Please recall that TLT prices move inversely to interest rates. When bond prices rise, interest rates fall in an opposite pattern.

Not shown here is the well-known 25-30 year bull market trend in Treasuries, with the current rates roughly in the middle of a well-defined channel.

The 2-century charts of long-term U. S. interest rates you may have seen also show that the 30-year bond, trading around 4.6%, is right at its long-term rate. So if you buy TLT, you are basically getting historical yield. You are not accepting the horrible yields available in the short maturities.

Why consider a trade in Treasuries besides playing for support near 90 to hold once again?

Fundamentally, whatever resolution comes from the healthcare reform effort can be good for bonds. If the Senate bill passes, it imposes tax increases before the big spending kicks in. So that's bond-friendly. If it fails, investors can take heart that the ever-expanding Federal behemoth has been stopped in at least one of its growth paths, and thus dream on about smaller government and a longer-term reduction in the tax/spend/borrow dynamic.

Moving to economics, various indicators such as that of the Economic Cycle Research Indicator suggest that the economy is nearing its fastest rate of growth for this cycle, with ECRI's weekly leading indicator showing steadily waning near-to-intermediate term growth momentum.

In relation to stocks, the long bond has a relative valuation that has been good to bond-owners in the past.

In or about 1960, the yield on the long Treasury exceed that on the average stock for the first time in U. S. history. By 1965, it is said that anyone who bought 20-year Treasuries, held for one year, then bought a new 20-year Treasury outperformed a buy-and-hold strategy in the stock market. Certainly, since then whenever Treasuries yielded at least twice the S&P 500 dividend yield, Treasuries were the superior buy. A bit over a year ago, there was a brief time when stocks had fallen so low, with fears of much more dividend reductions, and Treasuries had fallen so low in yield, when dividend yields exceeded long T-bond yields.

Thus we can think of a fundamental range for these different financial assets. If you believe in stocks, buy when dividend yields approach Treasury yields. Be cautious on stocks at a 2:1 yield ratio. Right now, the S&P 500 yields about 2%. The 20-year T-bond yields over 4.2%.

Please remember that with stocks, all a long-term holder keeps in his/her pocket are the dividends. A dividend yield of 2% that grows at 5% per year doubles its yield to 4% in 14 years assuming the stock price stays constant. Remember that stocks historically have yielded 4% as a baseline, and in the roaring '20s, yields of 7% and above were quite common. Thus, stocks may well fall in price even as dividends are increased again.

If you want to get scared about stocks, please click HERE to find historical evidence that a 1/3 drop in the average stock would simply bring stocks back to fair value.

Some final points. If one were to speculate in TLT or its 7-10 cousin ETF "IEF" (which has a "stronger" chart), one can see danger ahead if support were to be broken. This is the near-hyperinflation scenario. Holders of gold or other inflation hedges are especially well-suited to live with that risk.

The other point is that as a continuous holder of bonds, there is no maturity of the bond to bring the price back to 100 (par). Thus there is in theory greater risk in owning a mutual bond fund or ETF than an individual bond itself. Over the short term, however, that risk is negligible, and a discount broker's commission structure plus the ultra-low overhead costs imposed on the ETF, along with minimal bid-ask spreads, make TLT and IEF superior trading vehicles for Treasuries than buying an individual issue. If one really wants to be a long term owner of Treasuries as a portion of one's portfolio, then direct ownership of individual bonds is probably superior to an ETF or mutual fund.

The case against Treasuries can be boiled down to irresponsibility in Washington as well as in the states that ultimately Washington may have to bail out. Plus, whenever Democrats have controlled both houses of Congress and the White House ever since LBJ took office, interest rates have trended upward.

Purchasing TLT and IEF would therefore be seen as a counter-trend purchase, perhaps banking on market hopes for a big midterm sweep for Republicans, in which case history would be much kinder to Treasury holders.

Copyright (C) Long Lake LLC 2010

Treasury Long Bond Refuses to Die

Every time I get ready to toss in my optimism for the chart on the Treasury long bond's price, using the ETF 'TLT' as the proxy, it hands in there despite an allegedly booming recovery. The latest chart pattern is shown here. The green line represents the short-term, 10-day moving average. Coming off a low price/high yield 90 days ago at the left of the chart, what one sees is a strong move up in price , with a peak in the 10-day ma around 95. After a dip in price, the 10-day ma now peaked at 96, had a mild dip, and has begun to point upward.

It's early, but this is how bull moves can begin.

Fundamentally, such non-standard indicators as Gallup's daily polling continue to show miserable reports from real people of hiring/non-hiring at their employers. The Baltic Dry Index hit yet another reaction low, and the Chinese stock market has hit a small air pocket the past few days.

I'm no economist; but . . . If Gallup has it right, a 10% unemployment rate is imminent (barring the technicality of a major shrinkage of the labor force).

Copyright (C) Long Lake LLC 2009