Trader’s Narrative

Yesterday we looked at the strange behavior of US mutual fund holders in shunning equities and stampeding into bond funds. That lead to lively discussion with different comments on what this means. Leaving aside the various arguments on whether this is a good or bad omen for the stock market, let’s explore the US retail investor’s sudden love for bonds.

We’ve just woken up to the realization that we have our own “lost decade” for stocks. From 1999 to 2009 the worst asset class you could have chosen would have been equities. In contrast Treasury bonds returned 110%, second only to gold.

But similar to the importance of timing the stock market, when you purchase bonds is pivotal to success. While we use metrics like P/E ratios or price dividend ratios to gauge the stock market, the bond market is much simpler. According to a study by Vanguard, all we have to do is look at the current yield. If it is low, the future returns will be similarly low. If high, then future returns from bonds will also be high.

You can download the report from the Free Trading Resource section (Reports & Articles folder: “The Historical Impact and Future Implications of Extraordinary Markets”). Here is how they explain their historical study:

…we put the historical yield levels for the 10-year constant-maturity Treasury bond into quintiles and show the range of returns over the next 10 years for those initial yield levels. For example, with an initial yield between 7.8% and 14.0% (quintile 1), the subsequent 10-year returns have been between 6.6% and 12.3% per year. Intuitively, these high returns stem from the fact that higher initial yield levels have been followed by systematically declining interest rates over the subsequent 10 years.

Here’s the resulting chart:

In late 2008, during the darkest days of the financial crisis, the 10 year Treasury bond yields sunk to 2.2% (5th quintile). The current yield on the 10 year is 3.44% which puts it in the 4th quintile. Based on historical data (from January 1928 to December 2008) the median return for the decade ahead is only 3.2%. And if you really want to get technical, you would subtract a reasonable inflation rate - say 2%? - which would bring the return to almost zip.

This study proves what we all know intuitively. Current rates are extremely low and the probability is therefore skewed towards rising rates, which means lower future returns. The higher the rates rise, the lower that return. So if you really believe in the inflation boogey man, you would be actually avoiding bonds not running into their arms as the average US retail investor is doing right now.

Instead of buying bonds, if you expect runaway inflation, you should be buying Treasury inflation-protected securities (TIPS) - bonds whose coupon increases along with inflation, and decreases with deflation.

A surprising number of retail investors are doing exactly that right now. Here’s an excerpt from a recent article from the Wall St. Journal:

Richard Seelig, a retired high-school math teacher in Pelham, Mass., bought shares of the iShares Barclays TIPS Bond Fund last December for his Roth individual retirement account. “I looked at the amount of money the government was spending that it didn’t have, and I thought, well, that is going to come back to haunt us,” he says.

But we are not in an inflationary environment right now. The yield gap between TIPS and normal Treasuries is 1.8% implying that that is the inflation rate in the US right now. But that may be deceptive for two reasons. Everything we’re seeing right now in terms of economic measures is signaling strong deflationary pressures. And two, the strong retail demand for TIPS has pushed their prices higher.

Even as retail investors rush to put their money into TIPS, there is no guarantee that they will see a payoff. This is because as inflation is sighted by the Federal Reserve, they will raise interest rates. And as interest rates rise, the value of bonds will decline.

So current buyers of TIPS are not only betting that inflation will be higher than 1.8% in the future, they are also betting that the Federal Reserve will be a pushover. That assumption may come back to haunt them.

If the above arguments are not persuasive, here’s another. Based on the historical data for US bonds, Prof. Jeremy Siegel has plotted a cumulative return for this asset class over the very long term (chart to the left). Total bond returns move in slow, multi-decade arches swinging above and then below a regression line (red). Right now, the cumulative return for bonds is extremely high relative to their historical trend. A reversion to the mean will happen. The only question is when and how fast. For more information on this valuation approach, see this article from MarketWatch.

Two Wrongs
If the shunning of equity funds by US mutual fund investors is bullish in your opinion due to contrarian analysis. Then it is difficult to not be labeled a hypocrite if you also believe in a future inflationary Armageddon. Either the “dumb money” retail investor is wrong in disbelieving the equity bull market, or they are wrong in expecting inflation.

While I completely understand and empathize with the traumatized psychological state of the average US retail investor, tragically, it looks as if they are jumping from the frying pan into the fire.