FYI | Jul 20 2016
By Peter Switzer, Switzer Super Report
One of the greatest worries I have at the moment is the bond market. I have had this fear for some time and it’s because it has been screaming that something is wrong with the economic world we live in and it’s why yields on government bonds have been going lower and lower.
And while a low bond rate or yield should be good for stocks, especially dividend paying stocks, the lowness of these rates have been sounding out an alarm which says “beware!”
All of this concern, just as the S&P 500 and the Dow Jones indexes have hit all-time highs this week makes more sense when you are privy to what bond market experts have always told me. To sum it up in a sentence it goes like this: “The bond market is usually right.” Some real bond market lovers have told me that “the bond market is always right” but that is hyperbole from biased bond guys.
The following chart shows you what has done well over the past year for someone in US stocks or US bonds.
Techie expert Carter Worth from Cornerstone Macro in the US has shown CNBC that while stocks, which are relatively risky, were up 2.72% since May 2015, the very safe bond play netted a 21.43% return!
How did that happen when bond interest rates and yields are so low and have been going lower? Well, for those bond funds that have bought bonds at 3% which we would say is low and then they go to 1.5%, then those 3% bonds are now worth a hell of a lot more!
The simple rule of the bond market, which I learnt and taught at the University of New South Wales many years ago was if interest rates are expected to fall then current bonds at relatively higher rates than what will be around in the future become more valuable and demandable.
Those who demand these bonds will raise the price they are prepared to pay for the bonds in trying to seize a bond with a higher coupon rate, which becomes more valuable when newer bonds have a lower coupon rate on them. It gives rise to the simple rule of thumb that when bond prices rise yields fall or when rates fall bond prices rise.
But why do bond prices rise? Well as I said it’s because there is a view that current bond interest rates look relatively good. If the majority of influential investors are scared about the future then they will get out of stocks and rush to the safe haven of bonds. The new demand for bonds pushes up the price of existing bonds and because you are paying more for a bond with a set interest rate on it, is effectively pushes down the yield.
And for about ten years and especially since the GFC of 2008 bonds have performed as well as stocks but with a lot less risk! And what shocked me with Carter’s charts was that bonds beat stocks over 20 years but importantly with less risk.
Over the years I have used this chart to show why I liked stocks and it always annoys Paul Rickard because it’s not updated but it always shows the same story that says stocks are great but if you look closer at it, it also shows that bonds are pretty damn good, given their lower risk.
This chart shows that $10,000 invested in 1970 and checked out in 2009, one year after the stock market slumped 50% and then saw a 30% plus bounce back, meant stocks delivered $453,165 or 10.3% per annum, which is really good. Meanwhile bonds returned $285,039 but this is still a 9% per annum return. And considering the less risk, it makes a strong case for a reliable bond fund being in your portfolio of assets.
This all well and good but why is the bond market worrying me? It’s simple — the bond market is very often right and for years it has been bringing down yields as the scaredy-cats of the world have chased bonds and raising bond prices.
But last week bond yields started to rise and it was because the run of good news from Japan to China to the US economy to Wall Street all said, if you can discount to possible threat of a President Donald Trump, then the world economy looks like it’s getting better. My Saturday Switzer Super Report showed the long list of what I liked and here they are again:
- Our stock market hit an 11-month high by the end of the week.
- That was seven days in a row of rises.
- We broke the important psychological level of 5400 to finish at 5429.6 on the S&P/ASX 200 index.
- The banks were back in favour.
- Chinese economic data gave it to those China-haters out there, with GDP up 6.7% (with the consenus forecast at 6.6%) but there were doubters with lower guesses.
- The landslide win for Japanese PM Shinzo Abe’s party in the Upper House and the assumption that a big spending program would ensue because of the strength of the victory.
- The S&P/ASX 200 ended trade 0.3% higher (or 18 points) to 5429.6 on Friday (up 3.8% for the week), its strongest gain in three months. The All Ordinaries ended 0.3% higher to 5510.1.
- The US stock market indexes – the Dow and S&P 500 – both beat their all-time highs.
- The Russell 2000 index, which is a key broad, small cap index, is trading above important technical levels creating a strong bullish technical pattern. It’s all-time high is 1290 and it’s now at 1205.31. If this record is broken, the techies see it going to a huge 1400!
- US bank earnings have beaten market expectations and banks’ share prices there were up 5% for the week.
- US retail was up 0.6% in June, versus the economists’ collective guess of 0.2%.
- And it’s not just the American consumer looking good but along came a 0.6% increase in industrial production for June, which is the best gain since July 2015 and the consensus forecast was a low 0.2%.
- Finally, US bond yields have headed up this week and that’s something you have to cheer about because this bond market’s behavior has been warning all of us to be very, very careful. I have been asking a lot of my bond market experts about how often the bond market gets it wrong. Now they are biased, being current or ex-bond people but their answer was what I expected: “Not very often!” Looking at the story I’ve bullet-pointed above, this could be one of those times.
This list was great news but along came the Turkey putsch and bond yields fell instantly, which shows how scared the world of investors are right now. That said, the short-term nature of this coup will probably see the higher yield position of bonds reassert itself.
The bottom line is when the world economy and the associated stock markets prove that we are heading in the right economic direction, when companies are growing healthier profits and balance sheets, and we don’t need to rely on central banks, well the bond market will have a bad day at the office.
There has been talk of a bond market implosion when economies respond to quantitative easing but they have taken a damn long time to do so. Even the success of the US economy has been discounted by the troubles in the EU and the UK post-Brexit, worries over China and even Grexit spooked the Fed, so interest rates are still on hold.
I reckon the bond market reigns supreme until the Fed can raise interest rates and the stock market actually likes it.
I hope it happens by December this year but a lot of bond market experts are betting against this and that worries me a little. I will remain long stocks but as you all know I have continuously argued that I am cautiously positive and the bond market has been the reason for that.
Peter Switzer is the founder and publisher of the Switzer Super Report, a newsletter and website that offers advice, information and education to help you grow your DIY super.
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