27 Aug 2010 Double ‘Bubble’ Toil and Trouble
Shakespeare begins his famous play “The Tragedy of Macbeth” with three witches imparting their prophecies to Macbeth, the would-be king. Unfortunately, prophesies as Macbeth learned, do not always turn out as expected.
The latest foretelling gripping investors’ fears, actually for the past three years, is that a ‘bubble’ in US Treasurys is about to burst. Hyper-inflation is just around the corner and US Treasury bonds, driven up in price to record levels by unprecedented policy measures, are about to crash. Here are but a few of the prophesies on the subject. Please understand is it not my intent to label these ‘seers’ of the future as witches, but they have put themselves out there as forecasters, and we will treat their comments accordingly.
“When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990’s and the housing bubble of the early 2000’s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.” Warren Buffet
“Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these high-fliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a decade ago…
A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds… The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout…
The possibility of substantial capital losses on bonds looms large. If over the next year,10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?”
Jeremy Siegel and Jeremy Schwartz
Besides being overly theatrical, these prognostications have several inherent and fundamental flaws. We will analyze the flaws in a moment, but first let’s explore the greater damage they wreak for individual investors. Today’s sensationalized noise about bubbles and crashes is scaring the daylights out of ordinary investors who ultimately depend on the returns of the capital markets to meet life-long goals, such as education for their children, funding pre-retirement goals such as second homes, a comfortable retirement, and ultimately, perhaps, passing on a legacy to their children or others.
Truth is, over the past 75 years, the capital markets have provided sufficient returns to meet virtually all savings requirements. An allocation of all stocks has returned an average of 11.5% while an allocation of 30% stocks and 70% US Treasurys has returned 7.6%. An investor saving just $3,000 a year at 7.6% will have $640,000 in 40 years.
The problem, of course, with the projection just stated is that it assumes a steady return of 7.6%. But the timing of capital market returns is not consistent and losses can occur in any given time frame. This risk is known as systemic risk – the risk of loss inherent in the markets. Any investor who buys into the bond or the stock market accepts systemic risk.
There is a second and significantly more dangerous risk that investors take, perhaps unwittingly, because their trusted advisors do a poor job of explaining it to them. This risk is known as non-systemic risk. It is the risk beyond that of the capital markets as a whole. It occurs when an investor seeks better-than-market returns by concentrating assets in areas he or she believes will out-perform the overall markets. Doing so adds greater uncertainty to the mix. There is the possibility of beating the market, but there is also the strong likelihood of under-performing it – significantly.
Combine the threat of under-market performance with the uncertainty of when these losses will occur and the investor has significantly increased timing risk in his savings plan. If under-performance adversely aligns with a point in one’s lie life when spending must occur, like college education or retirement, he or she will wind up spending from a pool of funds more diminished by active management than if it were simply invested in the indexes.
Now here’s the point. It is this extra amount of risk, which is needlessly injected into portfolios of the investing public, that may very well provide the ‘straw that breaks the back’ of their confidence. In increasing frequency I hear people say that their friend, or their mother-in-law, or their barber has just sold out of the market ‘forever’ and invested their money into gold or silver, or pottery jars, or the credit union. The sad truth is that the investment industry is largely to blame. Even sadder, is the fact that these people will almost certainly pay a significant price in reduced lifestyles down the road for choices they make today out of needless fear.
Now back to the latest fear sensation cooked in the cauldrons of the Wall Street media. Quoted above are Mr. Buffett and Mssrs. Siegel and Schwartz for their notoriety. But there are many others whose claims are even more dramatic. Mr. Buffett evokes the Internet Bubble of the late 90’s and the more recent housing bubble for effect to make his dire warning. Siegel and Schwartz have the audacity to compare the Treasury bond market to the NASDAQ of the late 90’s where “tech stocks selling in excess of 100 times earnings … declined 80% or more.” Do they really mean to imply that a 10 year Treasury bond is in any way comparable to stocks trading at 100 times earnings?
A drop of 80% in a stock price is not even remotely comparable to a drop of 3% or even 9% in a bond’s price. With Treasury bonds in particular you are guaranteed to get back more money than you paid for them if you hold them to maturity. I know there are some who say the US government is going to fail soon, but that does not appear to be in the cards in the next decade or two. Japan for instance is operating their national affairs with a debt more than twice that of the US’s debt relative to GDP.
So how likely are we to see Treasury rates rise enough to cause “extraordinary” losses as the ‘bubble’ bursts? While the past never repeats itself we all use it and our experience to provide a framework of expectations for the future. I can think of an entire industry built on the premise that a good track record is an excellent predictor of future results, even while the regulatory agencies make them disqualify such implications in the small print.
The 7-10 year Treasury index we use in our clients’ portfolios is relatively new as an index. The data does not go back far enough for effective comparisons. Dave Loeper of Wealthcare Capital uses a blend of 40% 5-year-plus Treasuries and 60% 5-year Treasuries as a viable substitute for the 7-10 year Treasury index. From this point forward the yields mentioned will be from this allocation.
So just how badly have holders of intermediate Treasuries been harmed in any one-year period during modern history (since 1926)? The worst performance for our hybrid 7-10 year Treasury was the 12-month period ended March 1980. It was down just under 10%. If you were around then you might recall that inflation was near 10%. What the bond-crashers are not telling you is that in the three years that followed, the 7-10 year Treasury index was up +11.26%, then +7.34%, and then +31.8%. Does that sound like a crash or a bump in the road?
What about the worst of US economies, the Great Depression? Over the near-decade long contraction of the economy from 1929 to 1939, interest rates fell from 3.83% to 2.14%. By the end of the Depression treasury yields had dropped to lows of 2.14%. Market forecasters were likely even more emphatic in calling for a bubble than they are today with the 10-year trading at 2.61%.
In the years that followed the Great Depression and particularly in the years during WWII the stock market soared, unemployment dropped precipitously as women came into the workforce to replace the men going to war. Commodities were in such short supply they were being supplemented from the kitchens and garages of every American family. Inflation was at all-time highs.
Applying Mr. Buffett’s and Mr. Siegel’s logic, the Treasury market ‘bubble’ should have burst sending prices crashing to the ground. In fact, however, in the 11 years that followed the Great Depression, there was only one down year in which the Treasury index lost .6% in total return. Remarkably, at the outset of WWII in 1941 Treasury yields dropped from 2.17% to 1.17%. Yes 1.17% on the 7-10 year hybrid.
During the ‘nifty 50’s’ with post-war peace and re-construction, a population explosion, the well-oiled war-time economy was transformed into a world-class production system. During this period it was common for the stock market to return 30-45% a year. P/E’s on blue-chip stocks reached the 50’s. Treasury yields went from 2.14% to 4.14% during the 50’s. The worst one-year decline was 3.7% and none back-to-back.
Finally, from the period from 1960 to 1993, the highest period of inflation on US record books, there were only two years when the index lost money: 1967 down 3.05% (stocks up 28% that year) and 1969 down 2.4% (stocks down 10.9%). In the two years following, treasuries were up 15% and 11%. In fact there were six years in this period when treasuries produced more than a 15% annual return.
So why would such esteemed men ignore history in their forecasts? Giving them the benefit of the doubt one might argue that they don’t think history has any relevance in this ‘new normal.’ But isn’t that similar to the mantra of the late 90’s that ‘earnings don’t matter because the Internet changes everything?’
It was Wall Street analysts who told us to keep buying tech stocks even at 100 times earnings because that was what they had to sell. Dot coms were coming to market faster than the ideas behind them (if there were any) could be explained. Ideas of diversification and allocation were thrown out the window. Even Fortune magazine had Mr. Buffett’s picture (who famously sat out the tech rally) on the cover with a caption asking whether the ‘oracle’ had lost his way?
Just as it is in Wall Street’s interest to sell what they can make money on, it may be just as possible that these ‘bubble’ prognostications have some amount of self-interest baked into their forecasts. Mr. Buffett’s comments come from his annual letter to stockholders. His comments have to be taken in light of his company Berkshire Hathaway’s interests. Berkshire Hathaway is not managed to confidently meet the needs of any one individual, but all of its stakeholders. In fact, the volatility of Berkshire’s shares has been considerably higher than the stock market as a whole. Mr. Siegel is an advisor to and has a financial interest in Wisdom Tree equity funds. He makes money selling stock funds, not treasuries.
There is no way to know what tomorrow will bring. Placing out-sized bets, particularly with one’s lifetime savings, on prophesies is not a sound strategy. Even if the prophesy comes true, it rarely does so literally. Recall poor Macbeth. Yes he became king, but in the end he lost his head.