01 Jun 2012 Treasuries Remain the Best Hedge Against Equity Risk

Europe is unraveling and signs are mounting that the global recovery is in jeopardy. A Chinese purchasing managers’ index showed manufacturing grew less than estimated last month in that country, the weakest production growth since December. Manufacturing, the stalwart of the US recovery, grew at a slower pace in May in response to weakness in the global economy. A similar gauge of manufacturing in the 17-nation euro zone fell to a three-year low of 45.1 in May. And unemployment in the US unexpectedly increased providing further evidence that the labor-market recovery is stalling.

Economic reports are confirming what markets have feared since April began – the recovery is faltering. The Dow Jones Industrials are now flat for the year, the S&P 500 is down 8.8% since April began, however still up 2.2% for the year. Bonds have confirmed the economic slowing thesis, as measured by the Barclay’s Aggregate Bond index; rising 1.5% since April began. This index measures all kinds of bonds, including corporate and mortgage.

But investors fear more than a global slump as evidenced by what is going on in the sovereign markets of the world’s economic leaders. There has been unprecedented demand for US, German and Switzerland sovereign debt. Yields on the German two-year bond went negative last week. US Treasury officials are considering offering negative yield bonds at auction soon.

Investor fears are rising to the point of capitulation. They are saying that as low as yields are, they can still fall further. Since April began, the 7-10 year US Treasury index is up 5.6% and the long-term US Treasury is up 7%. These returns are a mirror image of stocks as measured by the Dow and the S&P 500.

In today’s Wall Street Journal, titled The New Fear Gauge: Treasury Yield,  Matt Phillips  suggests that “after denial, anger, bargaining and depression, investors seem ready to enter the final stage of grief over low yields: acceptance.” The final stage of any bull market cycle, indeed of any bubble, is capitulation. The last holdouts finally throw in the towel and buy at admittedly ridiculously high prices that show no signs of reversing. This time, however, its not about greed, but fear. People are no longer concerned about the return on their money, but rather the return of  their money.

For the past six years we have used a 7-10 year US Treasury index ETF to fund the fixed income portion of our clients’ portfolios (some of our clients own AAA 7-10 year municipals instead for tax considerations).

The reason for Treasuries quite simply is that no other asset class has proven superior as a hedge against equity risk. In the last six years our clients have seen their Treasury holdings grow at just under 9% a year including interest. If you invested $100,000 six years ago in the 7-10 US Treasury index you would have $162,830 today (in blue in the table below). That amount compares favorably to the $113,360 you would have if you invested the same amount in the S&P 500.

But, That Was Then, What About Now?

We are not in the business of predicting market cycles or making investment recommendations that amount to guesses (educated or not). But if your portfolio hedges have let you down in the past several years and you are now considering Treasuries as a last resort, you understandably face some significant concerns.

One: Treasury prices are at all-time highs and yields at all-time lows – how much further can they go? The answer quite simply is, yields can go to zero and below if economic conditions drive people to the point of abandoning yield to seek only the guaranteed return of their money.

Two: Given the US level of debt and seemingly endless propensity to spend more than it earns, what happens if the US goes broke? This great country has survived a war of independence, a civil war that destroyed more human life and productive capacity than all other wars combined, two world wars, and a Great Depression. The odds of going broke are not zero, but they are considerably low for the foreseeable future. Nobody ever lost a dime investing in US Treasuries and holding them to maturity.

Three: As our economy eventually recovers we will likely experience horrific inflation which will send Treasury prices spiraling ever downward as other ‘bubble’ assets have done before them. While rife with excessive hyperbole from analysts and talking heads, this scenario is the most likely of the three. However the outcome will probably be far better than what you might have been led to fear.

Once again, let’s look to history to frame an answer. The next three tables represent work done by Dave Loeper, CEO of Wealthcare Capital Management. They represent considerable analysis of two distinct economic periods when inflation was extraordinarily high and they provide an excellent picture of how Treasuries and other ‘hedge’ vehicles performed under the pressure.

Table 1 considers the period between 1973 and 1975 when the trailing 12-month CPI spiked from 3.41% to 12.34%, before settling in at 6.94% by the end of 1975.

© Wealthcare Capital Management

Note in the table above that while inflation raged at 12.34%, the 7-10 Year Treasuries did not lose more than 1.82%. Compare that to gold which lost 25%, or real estate which lost 48%. Gold did of course benefit over the period as a whole, compounding at over 29% a year for three years. Treasuries produced a nominal return of 5.39% over the three-year period.

Table 2 considers the period from March of 1978 through February of 1982 when the trailing 12-month CPI went from 6.55% to 14.76% before settling back to 7.62%.

© Wealthcare Capital Management

This time the 7-10 Year Treasuries gave up 9.45% in a 12-month period compared to gold falling 36% and real estate edging a positive return of .23% in the worst 12-month cycle. Think of the Standard Deviation columns in both tables as a ‘scary indicator’ like you might find on an amusement park roller coaster. You can clearly see how scary it was to own gold, real estate, and stocks during these periods as compared to 7-10 Year Treasuries.

Finally, let’s not forget the most significant stock market slide in recent memory – 2008. As stocks tumbled 37% as measured by the Vanguard Total Domestic Equity index, the Barclay’s 7-10 Treasury rose by 16%. Gold was a distant second, but the others failed miserably in hedging the terrible equity declines that year.

© Wealthcare Capital Management

So history shows that during periods of extreme inflation, volatility and uncertainty, the 7-10 year US Treasury fares quite well. We cannot know how bad inflation will be in the coming years, but history does provide a framework for what we might reasonably expect.

Uncertainty is a powerful force and clearly reigns today keeping countless investors up at night as they fear yet another scary descent. We are in the business of continually measuring the uncertainty in our clients’ plans. As a result of April and May’s steep equity declines, 3% of our clients have fallen below our threshold of confidence we refer to as the ‘comfort zone.’ We are working on their plans and will present each of them with recommendations that honor their priorities to get them back on track toward meeting and exceeding their goals.

If you spend any of part your precious day worrying about uncertainty in your financial future, call us. We will replace uncertainty with confidence and opportunity – guaranteed.