It's Not About Market Timing: It's About Business Common Sense
- Discover how “safe portfolios” could be the riskiest of all.
- Explains why it is just simple risk vs. reward analysis based on valuations.
- Reveals the one action I'm taking to protect my portfolio.
What does the bond market today have in common with the stock market in 1998-2000 and the real estate market in 2006-2007?
They were all in ridiculous bubbles that ended very badly for investors.
This may sound like a bold prediction, but in fact, it's not. It's simple risk vs. reward analysis based on valuations.
This simple mathematical analysis has saved my portfolio twice from past bubbles and can save your portfolio this time.
(Editor's Note – I published this post in March 2013 and have not edited it since for transparency. Bond returns since that date speak to the integrity of the analysis that follows.)
Let's explore how it works…
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Treasury Bonds Bubble Analysis
Interest rates peaked back in September 1981 and have been falling ever since to reach today's extreme lows.
According to O'Shaughnessy Asset Management, 2013 provides the most difficult environment for generating income in 140 years. Since 1871, there has never been a lower yield period in history – not even close.
The average historical yield on a 60% equity / 40% bond portfolio has averaged 4.36%, and is now at an all time low of just 2.0%. Clearly, we are in extreme territory for low interest rates.
In fact, research on 30 year bond rates going all the way back to before the Civil War (1790) shows the United States has never been able to borrow long-term capital more cheaply than it can right now. Unbelievable!
Further proving how extreme our current point in history really is, Timely Portfolio's did a fascinating study on 10 Year U.S. Treasuries (constant maturity similar to IEF) evaluating what would happen if interest rates went to their theoretical minimum – zero.
Are you ready – drum roll please – a paltry 17% gain. Shocking, but true.
That means that if interest rates went as far as they could theoretically go on the downside, the entire upside left on 10 Year Treasuries is a mere 17%.
That's not much considering it's the mathematical extreme case limit for how far it could go. Your actual returns would depend on how long it took to reach this limit.
For example, Market Sci blog showed that if it took 4 years to reach zero percent interest rates, then the annualized return would be just 5%, and the total return would be 21.6%.
This may not sound too bad until you realize that 0% yield is not very likely. Given that Japan's record low yield for their 10 Year Note was .47%, it's interesting to note the maximum upside is reduced to a mere 13.8%.
If it takes 4 years to get there, your annual return is just 4.1% with a total return of 17.6% – before inflation! If you net out inflation, the real return is minuscule at best.
The implication is clear – the upside potential in bonds makes no sense compared to the downside risk.
The problem is bond prices move inversely to interest rates, and interest rates are approaching their theoretical floor. In other words, as rates decline, bonds rise in value. As rates rise, bonds lose value.
There is little room left for interest rates to fall, and tons of room for rates to rise, creating an unfavorable risk/reward ratio.
This problem is further exacerbated by the fact that current low interest rates would cause a modest rise in rates to cause disproportionately large losses that could dwarf any income received in the interim.
For example, as of this writing, a mere 1% rise in interest rates on the Treasury long bond should equate to a roughly 20% price decline, wiping out 7 years of income at current interest rates.
Do you think it's reasonable to expect a mere 1% increase in interest rates from these historically low levels over the next seven years as the above example illustrates? After all, far worse has occurred in the past when markets were less volatile.
For example, the 30 year Treasury yield rose 240 basis points in just 9 months back in 1994. Just imagine what a 2 – 3% rise (or more) would mean to investor portfolios given the above example.
Why the Bond Bubble Is More Important Than Previous Bubbles
This is critically important because fixed income's traditional position within asset allocation is as a “safe investment“.
In fact, we have entered one of those rare points in history where the risk/reward analysis on bonds could conceivably be more dangerous than equities, because the historically low coupon implies historically unprecedented volatility and downside price risk.
In other words, capital loss risk to bonds is highest when starting yields are lowest. Given that yields are at all time historical lows, many historical benchmarks for capital losses in bonds are unrealistically conservative. The future could easily be far worse than the past.
For example, according to Welton Investment Corporation the deepest (-15.3%) and longest (8+ years) Aaa corporate bond drawdown occurred from 1954-1963 because of a tiny 1.8% increase in interest rates – a hiccup by today's volatile standards. The reason is because the starting yield in 1954 was an equally tiny 2.85%.
In other words, the drawdown severity and duration isn't determined exclusively by the magnitude of the interest rate rise. It's determined by the relationship of the interest rate increase compared to the starting yield. Today's record low yields imply historically high risk of capital loss.
For example, Welton also analyzed what could happen to Aaa corporate bonds under different interest rate increase scenarios:
- A 6% increase spread over 5 years would result in a 36.2% drawdown and a 6.4% annual loss.
- A 4% increase in just 1 year would result in a whopping 34.8% drawdown and a 34.8% annual loss.
- Even a modest increase spread over many years could cause zero return (or worse) for more than a decade.
These losses may not look horrific by equity market standards, but it's important to note the money parked in top quality bonds is considered “low or no risk”. That is clearly no longer the case, and it has serious implications for traditional asset allocation models.
Some might argue that if you hold the bonds to maturity then price risk is only a temporary problem, but that's a dangerous half-truth.
Today's investors frequently hold their bonds in diversified pools of mutual funds and ETF's, giving up any ability ride out the downturn and hold a specific bond to maturity. The losses can become permanent.
Whether you think interest rates will rise or not is irrelevant. The point is the downside risk of loss is high in what many investors consider to be their safest investments, and they are getting paid paltry returns to accept that risk. The risk vs. reward ratio is absurd. It makes no sense.
In short, the risk to fixed income portfolios is extraordinary right now.
Given the unfavorable risk/reward ratio, what should you do as an investor?
That depends on many factors including your investment goals, time horizon, specific portfolio composition (duration, quality, etc.) and how much interest rates actually rise.
Of course, I don't have a crystal ball and have no clue when and to what degree interest rates will rise. I just know it will eventually happen, and the downside risk when it occurs doesn't justify the return being offered to accept that risk.
That is the only relevant point. The math is unequivocal on this fact.
The only questions remaining are timing and severity – both are complete unknowns.
What we do know is eventually, investors will demand greater return to accept the risk associated with lending their money. As nations become increasingly in debt, how many more short-term fiscal manipulations can be applied to keep interest rates artificially low?
I don't know (and neither does anyone else).
What we do know is a turn of the tide in interest rates is merely a question of when – not if.
And yes, I'm fully aware that naysayers have been saying the same about Japan for a very long time and been completely wrong. True! I'm the first to admit this analysis says absolutely nothing about timing – a critically important fact.
The bubble could continue for years before turning, but that doesn't change the mathematical reality that it's clearly a bubble — risk to reward analysis makes no economic sense.
Would you lend to the U.S. Government for 5 years for an 88 basis point return? Nobody in their right minds should risk substantial downside losses for a maximum potential upside gain close to zero (or worse) net of inflation.
What Can You Do to Protect Yourself?
I'm not in the investment forecasting business.
I rarely write posts like this because forecasting financial markets is a fools game that has no place in sound investing. The future is unknowable and anybody who plays in forecasting the market is destined for humility.
What I'm sharing with you here isn't a forecast. It's a risk/reward analysis of a broad market sector based on mathematics.
There are rare times when valuations in specific markets reach such absurd levels that the risk vs. reward ratio allows you to make investment decisions without any specific forecast.
I've done this twice in the past (publicly), and I'm doing it a third time right now.
- How did I know to sell all my investment real estate in 2006 right before the market top?
- How did I know to sell my investment management company in 1997 and remove traditional equity allocations from my portfolio 3 years too early before the big top in stocks?
Actually, I never knew either market was at or near a top. That would be a forecast.
All I knew was the risk/reward analysis was extraordinarily unfavorable to where participating in that market no longer made sense. It was based entirely on business common sense and required no forecast.
I want to be clear that I had no idea when the actual market tops would occur in the past or how they would come unwound, and the same is true with the bond bubble today.
For example, when I sold my investment real estate holdings in 2006, the only thing I knew was my $600/month apartment tenants who didn't qualify to rent from me were getting 30 year mortgages on $300,000 homes.
I knew their credit and rent payment histories as their landlord, and I was 100% certain they didn't qualify under any reasonable lending standards – yet they somehow got loans. (Of course, we found out after that fact there was massive lending fraud.)
I also saw the real estate investment deals my financial coaching clients were examining. Valuations got so absurd near the top in 2006 that deals were transacting where it was literally impossible to make money from operating the property.
Even if you had zero vacancy, no maintenance costs, no turnover costs, and none of your expenses ever increased, the property would still be cash flow negative.
The only possible way to profit from ownership was if a greater fool came along and paid an even stupider price for the property than was being asked at the time. It was a recipe for disaster.
It doesn't take a rocket scientist to see the risk to real estate when the absolute lowest credit quality buyers are already fully invested in the market, and prices are so high they make no economic sense using absurdly optimistic assumptions.
The balance of supply/demand had to tilt to the downside. It was business common sense.
What I didn't know was when or how much real estate would decline. The fact that selling all my real estate by the end of 2006 was nearly perfect timing was actually total luck.
Truly, I had no idea.
The real estate markets could have remained overvalued for years and gone to even more unfathomable extremes. I didn't know where and when the bubble would end. I just knew it was a bubble and the valuations made no sense.
I sold my properties for more than two times as much as I was willing to pay for them, paid the taxes on the gains, and never looked back.
Similarly, when the stock market bubbled in the late 1990's, I eliminated all of my traditional equity allocation in my portfolio, and sold my investment management company by the end of 1997. In this case my timing was way too early.
The markets continued to rise relentlessly, going from ridiculously overvalued to unbelievably overvalued before the final top in 2000. Again, it's just business common sense that when the entire NASDAQ index is selling for more than 200 times earnings at the top, it can only end badly.
It was just a question of when – not if. The valuation was unsupportable. It was business common sense.
Heck, I even had a client end our relationship when I started teaching him how to understand the risk inherent in his 100% tech stock portfolio. He was blind to the message and lost most of his net worth in the downturn that followed.
The psychology was absolutely frothy, and amazingly, it continued that way for years, creating the most overvalued stock market in U.S. history.
I had no idea on the timing for the bubble burst, and in this case, I was way too early. Ultimately, the position was vindicated by the massive decline that followed, but I want to be clear that this type of analysis tells you absolutely nothing about timing – only ultimate outcomes.
The markets can remain irrational for far longer than you can remain solvent, so be careful what you conclude from this analysis.
And that brings us to today's bubble du jour – the bond market. I have absolutely no clue when the final top will occur. It could finish this week or continue on its merry death march for a few more years.
It's impossible to know because nobody can predict the future… least of all, me.
With that said, what you know from the above analysis is supply/demand is now grossly out of whack. According to Fidelity, more than $1.1 trillion was allocated into bond mutual funds and ETF's since 2007, while equity funds received just $33 billion – an astonishing 33 times more to bonds than stocks.
Bank of America provided similar numbers, showing U.S. investors pulled $600 billion dollars from U.S. equity funds while simultaneously adding $800 billion to bond funds – a massive, one-sided tilt in allocation.
Research demonstrates that extreme, multi-year capital inflows into an asset category has historically lead to unfavorable risk/reward ratios in subsequent years as reversion to the mean takes hold.
According to Reuters, even the biggest names in bond management (PIMCO, Loomis, DoubleLine) are making business moves into equity funds and diversifying their businesses. The writing is on the wall.
Bottom line is valuations make no sense in the interest rate market. Would you loan money for 30 years at 3% to a government that is so deeply in debt that it's mathematically impossible to repay its debt? Of course not! It's insane. Completely insane.
Yet, fortunes are traded every day on that exact premise and people have major chunks of their retirement savings invested accordingly. Hopefully you will be wiser. Caveat emptor.
Appropriate Investment Strategy
Only you can decide what the appropriate investment strategy is for your portfolio.
This is an educational article and does not offer personal investment advice.
With that disclosure in place, you probably want to know what I'm doing with my own money given this information.
The answer is I will do the same thing I did before the stock market bubble burst and the real estate bubble burst: I exit the market.
Because markets can stay insane far longer than you can remain solvent, I never short a market based on risk/reward analysis. It makes sense for my investing to remove risk by eliminating or reducing market exposure based on unfavorable risk/reward ratios.
I'm willing to accept the risk of leaving the last few breadcrumbs on the table and being temporarily wrong for years in exchange for giving up the risk of being invested during the highest risk periods when mathematical expectation is unfavorable.
Others may view their investment situation differently and be equally correct. For example, U.S. Treasury bonds are one of the few asset classes that have maintained low to negative correlation with equities in recent years, providing a valuable portfolio diversifier that has substantially reduced volatility in the past.
This is the math that governs how money compounds and it's inviolable. Mathematical expectation trumps all other investment considerations, and bonds show limited upside potential with strong downside risk.
You are now armed with the necessary knowledge. The choice is yours.
What do you think about this latest bubble situation? Tell me in the comments below…
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