Land of Confusion... Bubbles and Omens Dissected
Charles Schwab
Liz Ann Sonders
September 1, 2010
Key points
- Is there a bond bubble, or just a bubble in talk about a bond bubble?
- Should we heed the warning of the Hindenburg Omen?
- Investors should always remember that "past performance is no guarantee of future results."
The economic news has been mostly grim of late. We're sticking with our view that the recovery is square root shaped (a "V" followed by a stall), and there's little question that we've entered the stall phase.
In addition to the havoc the stall has wreaked on stock market volatility, it's taken yields on Treasuries to near all-time lows. This, of course, has generated a very strong upward price move in bonds (as bond prices and yields move inversely) and much talk about a "bond bubble." I want to address that in today's report while also highlighting another related hot topic—the "Hindenburg Omen"—later in this report.
Let me express my gratitude to Rob Williams, our bond expert, for his invaluable help and perspective while I wrote this report.
Bond bubble or justified move?
The latest rally in US Treasuries has taken the 10-year yield from an early April 2010 high of 4% to a recent low of 2.5%—only 0.5% greater than the all-time lows reached during height of the financial crises, as well as during the Depression-era 1930s.
Plunging bond yields
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Source: FactSet and the Federal Reserve, as of August 27, 2010.
The heightened returns (rising prices) these falling yields have generated, coupled with the surge of money into bonds and bond funds, have generated cries of "bond bubble!" The word bubble is probably a poor choice.
Bonds promise to pay a set amount at a fixed future date, which certainly can't be said about stocks and other investments. Stocks can fall 100% in value; short of default, bonds can't. This doesn't mean there aren't risks—were interest rates to begin to rise, prices will obviously fall.
Bonds are generally perceived to be safer investments and less volatile than stocks or other higher-risk asset classes, like commodities.
However, the financial markets have evolved with the advent of high-frequency and algorithmic trading, and time horizons by many players being measured in seconds and minutes. Many of these players are active in the same asset classes, sectors and securities while employing similar trading tactics. It has heightened the volatility of bonds and investors need to be mindful of that.
If a move higher by yields were to catch some momentum, it could trigger a move out of Treasuries that's more swift and painful than the fundamentals suggest given the dominance of program traders in the market.
Diversification and rebalancing not just for stocks
We recommend a plan that takes advantage of volatility and includes rebalancing and reallocating gains to areas of your portfolio that are underexposed. This may include taking some profits in longer-term Treasuries if you're worried more about price than income and, above all, not chasing gains too far.
As you can see in the chart below, mutual fund flows have been heavily biased toward fixed income and away from stocks.
Investors fleeing stocks in favor of bonds
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Data based on a 36-month sum. Source: FactSet, Investment Company Institute and ISI Group, as of June 30, 2010.
The uncertainty and demographics factors
Money has flowed into bonds because investors are uncertain, have increased their savings, or believe that return of capital is as important as return on capital for at least a portion of their portfolios. This is especially true for the skittish or those who need the money in short order.
There's little reason to believe this will change soon in light of the message(s) from the Federal Reserve and the demographics of an aging population. The Fed's interest rate policy has a 90% correlation with the direction of bond yields. Given the Fed's near-blatant insistence that rates will remain on the floor for some time to come—via its "extended period" phrase and its resolve to not let its balance sheet shrink—low Treasury yields and high prices have been justified.
Too big a shift to bonds?
Many investors have probably skewed their portfolios too far away from stocks and toward bonds. We're always believers in the power of diversification and rebalancing, and it doesn't only apply to the stock portion of your portfolio.
Since 1976, a well-diversified portfolio of Treasury, agency, mortgage-backed and corporate bonds (represented by the Barclay's US Aggregate Bond Index) had negative returns, after including price and income, in only two years. The worst year was 1994, a year when bonds got "killed." The loss was only 2.9%. In 1995, this diversified bond portfolio returned 18.5%, including price and income.
Since 1926, a portfolio of intermediate-term Treasuries, with an average maturity between five and 10 years, had nine negative years out of 84, combining price and income. The worst was -5.1% in 1994, followed quickly by a 16.8% return in 1995. During the 1970s, when rates were rising sharply, there were no negative years; again combining price and income.
Much has been made of the 30-year bull market in bonds, but that's only if you look at price, not income. Price only matters if you choose to sell, and is certainly more relevant if you hold bond funds versus individual bonds.
For most individual investors, falling yields on bonds over the past 30 years have only been a good thing so far as they've come with a more predictable rate of inflation. Today, low yields aren't a good thing for prudent savers and income-oriented investors.
Of bubbles and omens
Let me transition now to the stock market, since it's largely taken the brunt of the selling in favor of bonds and bond funds. A recent technical condition was triggered, ominously called the "Hindenburg Omen," that historically preceded most serious corrections and/or crashes. It got a tremendous amount of attention when it was first triggered August 12, but there's a relationship to the aforementioned discussion of bond market momentum that deserves some attention.
According to Bespoke Investment Group (B.I.G.), there are five criteria that need to be satisfied in order for the indicator to be triggered:
- The daily number of New York Stock Exchange new 52-week highs and daily number of new 52-week lows must both be greater than 2.2% of total NYSE issues traded that day.
- The smaller of these numbers is greater than or equal to 69 (2.2% of 3126 NYSE issues). This is not a rule, but more like a check.
- The NYSE 10-week moving average must be rising.
- The McClellan Oscillator1 must be negative on the same day.
- New 52-week highs can't be more than twice new 52-week lows (however, it's fine for lows to be more than double highs).
The rationale behind the first, and most important, criterion is that when large numbers of stocks are simultaneously hitting news highs and new lows, it's indicative of indecision and confusion in the markets—often a precursor to panic.
Dousing the flames of the Hindenburg
Looking at the list of news highs and lows from Thursday, August 12 (the first Hindenburg Omen trigger day), there were 92 stocks (2.9% of NYSE) that hit new highs and 82 (2.5%) that hit new lows.
However, a closer look at the list of new highs shows that most of the "stocks" hitting new highs were hardly stocks at all. Practically all were closed-end fixed income securities, preferred stocks or some other form of fixed income product masquerading as stocks. In fact, of the 92 issues that hit new highs, only seven were common stocks!
Given that there are so many fixed income products that now trade on the NYSE, and with demand for them so high, perhaps a better way to measure new highs (or lows) is by filtering out all the quasi-stocks. B.I.G. did this by looking only at stocks in the S&P 500® index and applying the same Hindenburg Omen parameters.
On the initial trigger day, only 0.2% of S&P 500 stocks hit new highs while 5.6% hit new lows. Of course, a day with 5.6% new lows doesn't highlight a healthy market, but it may not reflect the confusion that the Hindenburg Omen supposedly conveys. As B.I.G. noted, "Call us crazy, but an indicator that measures the internals of the equity market should probably avoid using fixed income securities in its analysis."
Past performance is no guarantee …
Again, what the details of the Omen confirm is the heightened demand for fixed income. It doesn't help that bonds have not only outperformed stocks during this latest swoon by yields, but also over longer periods, as well.
In fact, in a relatively rare occurrence, bonds outperformed stocks during the 20 years through 2009's first quarter when the stock market bottomed! In the chart below, you can see rolling relative returns of stocks (S&P 500) and bonds (10-year Treasuries).
A rare 20-year period of bond outperformance ending?
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Source: Bloomberg, FactSet and The Leuthold Group, as of June 30, 2010. TR stands for total return. ACR stands for annual compound rate of return.
Only twice before in history have we experienced such an extended period during which investors fared better in Treasuries versus stocks. I often hear this as the basis for portfolios now heavily overweighted in bonds versus stocks. If the warning about "past performance is no guarantee of future returns" isn't enough, heed the details of the chart above.
In the call-out boxes, you can see the relative returns in the subsequent five years after the peak outperformance of bonds over stocks. Although investors didn't lose money in bonds, they missed out on strong stock returns by bailing on stocks at the trough of relative performance (like in March 2009).
Investors must heed the call of rebalancing and remember that diversification is important both among and within asset classes. We're not bond bubble blowers, but no one ever went broke taking some profits.
1. The McClellan Oscillator is a market breadth indicator based on the difference between the number of advancing and declining issues on the NYSE, and is used to help determine overbought or oversold market conditions.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.
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