Bursting of the Bond Bubble

Our April newsletter focused on the extreme overvaluation in the bond market. I argued that money market funds (or cash) were likely to outperform bonds and bond funds over the next decade. In May I applied the same logic to US stock prices and the inherent fallacy in the prevailing TINA (“there is no alternative” to stocks) hypothesis. Although stocks are likely to outperform bonds over the next decade, both asset classes remain seriously overvalued. In a world of overvalued assets, zero return looks much better than large potential losses even when that means foregoing transitory gains. Just as there was no evidence at the time that seriously overvalued bond prices topped out last summer, there is no evidence that seriously overvalued stock prices have topped out now.

As you can see from the chart below, interest rates actually bottomed one year ago. Although masked by ups and downs, air has slowly seeped out of the bond bubble as rates have ratcheted higher. In the two months since that last letter, the bubble in the bond market has sprung a serious leak. Bond prices have plummeted as rates have risen. Investors who foolishly saw bonds and bond funds as safe havens have been subjected to large losses. It only took a few weeks for the additional losses on 10 year TBonds to exceed seven years of the interest that bondholders thought they were accruing. Lower rated bonds suffered even greater losses as credit spreads have returned to more normal levels.

Investors in stocks and precious metals are accustomed to short-termswings; people buy bonds specifically to avoid that trauma. In this sameperiod cash and money market funds maintained their value, as did stocks.Although stock prices have now posted token new highs, they have alsosuffered interim declines. Cash is the only asset that provided truediversification because it is always uncorrelated with other returns.

Despite the dramatic recent rise in bond yields and widening of credit spreads, there is no reason to expect interest rates to decline significantly on a sustained basis. Certainly the recent swoon has encouraged short sellers, who could get squeezed, but any drop in rates is likely to be short lived. After a modest recovery, TBond prices will fall further while other riskier income producing assets (the real bubble) will suffer even more. This seems counterintuitive to knowledgeable bond investors because over time the higher interest payments from “credit” instruments partially offset capital losses. Someday this strategy will work for those holding individual bonds until maturity, but not until after the bond bubble deflates.

Bubbles are not defined simply by the degree of overvaluation. That overvaluation needs to be accompanied by widespread investor enthusiasm and participation. The credit markets (primarily corporate and municipal bonds and to a lesser degree high dividend stocks) are still in bubble territory. Neither TBonds nor most stocks, despite serious overvaluation, enjoyed the investor enthusiasm characteristic of a bubble. Limited popular participation means the potential for a panic liquidation is much smaller.

The greatest factor driving bonds lower is investor redemptions of bond fund holdings. Unlike owners of individual bonds, bond funds cannot simply hold their bonds to maturity. When investors want their cash, fund managers must sell bonds to meet those redemptions, locking in losses. Thus the vicious cycle begins. Rising interest rates raise investor concern resulting in bond fund redemptions. Redemptions force sales of bonds by funds. Bond sales by funds increase the downward pressure on bond prices. Lower bond prices reduce the net asset value (NAV) of funds further, increasing investor concern. More concern equals more redemptions, etc, etc. The risks of a deflating a bond bubble are potentially much greater than a deflating stock bubble. Stock investors at least have some awareness that they are at risk. People typically invest in bonds to avoid risk and right now Americans have more money in bonds and bond funds than ever before.

The Bond Market

Despite the recent rise, interest rates will continue to ratchet higher. Hopefully you followed our advice and already refinanced your house a few months back while rates were at record lows. Bond owners who ignored our advice to reduce positions when rates were low may now find themselves trapped in illiquid securities that continue to lose value. The refinancing window may have passed, but you still have time to protect your wealth by selling any bond funds you own particularly if bond prices bounce following the recent severe decline. Although still overpriced and likely to decline further, the long-term return on high quality corporate and municipal bonds is now competitive with stocks. Unlike most of the last year or two, there is no longer any reason to rotate out of bonds into stocks.

Bonds vs. Bond Funds

It is important that investors distinguish between individual bonds and bond funds. Open-end bond funds are highly liquid. They can be sold at the same yield that buyers of similar funds would pay at any point in time, making them preferable to individual bonds when prices turn south. Unlike individual bonds however, bond funds do not have a maturity date. There is no guarantee that bond fund holders will get principal and interest by simply holding on.

How Far Will the Bond Market Decline?

As I pointed out in April, 10yr TBond yields have historically averaged a yield that matched either nominal GDP or 2% above the inflation rate. Both measures indicate yields around 3.25 – 3.6%. Since bond prices go down when rates go up, we should expect significantly lower prices since the current yield is 2.5% (up from 1.6% several weeks ago and 1.4% a year ago). When interest rates have been repressed (by the Fed) below that norm, upon reversal they typically rise an equivalent amount above that norm. How fast that occurs depends on future growth and inflation. If the economy sinks into a deflationary recession, bond prices will recover. If some combination of higher growth and inflation arrives in the future, bond losses will be even greater. Rather than rely on forecasts, just focus on the current reality. You clearly don’t want to own bonds until the yield on 10yr TBond exceeds 3.25%.

Collateral Damage to the US Treasury Market

Although there is no bubble in TBonds (which are primarily owned by the Fed and other banks), don’t assume they are a safe place to hide. Other than the Fed, the largest holders of TBonds are the central banks of China and Japan. Recently they have become net sellers, which is one reason prices have declined. Typically the reason foreign countries buy US TBonds is to reduce the value of their currency without inflating their domestic money supply. Now however, Japan is deliberately expanding the money supply so that US Treasury purchases are superfluous. China on the other hand needs to liquidate some of their hoard of foreign reserves (comprised largely of US TBonds) to support their rapidly slowing domestic economy. We can’t expect private investors to pick up the slack with bond prices falling. Furthermore, institutional investors stuck with illiquid bonds tend to sell TBonds short to hedge their losses. Bubble or not, bond prices have nowhere to go but down.

That’s the bad news, but there are a couple of bright spots. First, as mentioned earlier, bonds are no longer extraordinarily expensive relative to stocks. Second, the US deficit is declining in the current year, so the US Treasury will be issuing fewer bonds. Unfortunately, even these silver linings have their own clouds. Lower bond prices mean that the US Treasury will have to pay higher rates on the bonds they issue (increasing the deficit). Faced with an illiquid market in corporate and municipal bonds, institutional investors have sold US TBonds short to hedge their other bond holdings against higher interest rates. Now that widespread confidence in future Fed purchases has disappeared, those short sellers have been given a green light.

Collateral Damage to the US Stock Market

The same can be said for US stocks (which are held primarily by funds and other institutional investors). Stocks are not in a bubble like they were 13 years ago, but they are nearly as overvalued. Stock prices are more dependent than ever on the bond market. In most cycles, stock prices rise as economic demands drive interest rates higher. Rising corporate profits encourage rapid expansion, which then requires financing through increased borrowing. Usually those rising profits make stocks more attractive than bonds when rates are rising. Currently however, although profit margins are high, they have been falling for over a year, not rising.

The current cycle is anything but “usual”. For the past year or so the stock market bulls (we were among the bulls prior to that time) have been very lucky. All the reasons they cited that would justify rising stock prices…

  • Expected double digit earnings growth
  • Companies using massive offshore cash hoard to buy back shares
  • Falling interest rates
  • Individual investors rotating out of bonds into stocks

…have proven to be completely wrong. Stocks have gone up anyway. That’s what I call lucky. Conversely we have been 100% correct in expecting that:

  • S&P 500 earnings would fall far short of expectations (per share earnings flat-lining for 6 consecutive quarters)
  • Tax considerations would preclude using offshore cash to buy back shares (offshore cash hoards have grown instead)
  • Interest rates would rise and individual investors burned by two stock market plunges were two old (baby boomers control most of the wealth) to return to the stock market (they bought into the bond bubble instead)

Stocks rose anyway. Not so lucky for our clients and us.

I have never subscribed to oft quoted market “wisdom” that “I would rather be lucky than smart”, even though it would have made the past year a heckuva lot more fun. On the other hand, being lucky this time has nothing to do with being lucky or unlucky next time. Smart doesn’t mean you never make a mistake, but it does mean you learn from them and do better next time.

What both the bulls and skeptics like us failed to anticipate was a bubble in the corporate bond market. That bubble enabled companies to issue long-term debt cheaply and use the proceeds to buy back shares. Investors never came back to stocks, but companies borrowed heavily to buy their own shares. In a market with very low participation and volume, substantial net purchases by corporations drove prices higher; something we should have been watching more closely.

Maybe the bulls will get lucky again, but debt-financed buybacks are peaking. The bloodbath in the bond market has virtually eliminated new bond issuance. Corporations are still buying back shares with proceeds of previous issues, but the pool is shrinking, not growing. Despite optimistic forecasts, total corporate earnings and profit margins continue to shrink. According to Robert Gay at Global Equity Analytics & Research Service, 1st quarter profit margins on the companies in the Dow Jones Total Market Index shrank at the fastest pace in 20 years1.

That ongoing earnings shrinkage will become obvious to even the ostriches when it is no longer masked by reduced share counts. With total profits shrinking some companies that are unable to issue bonds (and no longer generating taxable profits) may finally bring back large chunks of that offshore cash. That environment is hardly conducive to rising share prices or additional buybacks.

The 500 largest US companies returned $87.70 in per share profits for the year as of the end of the Q1 2013, down from $88.54 a year earlier2. The losses would have been much steeper but for the fact that massive debt- financed share buybacks offset the effect on per share earnings. Total corporate profits suffered a more serious drop. Although earnings forecasts remain optimistic (as they have been erroneously optimistic for almost two years), it is generally acknowledged that any profits in the quarter just ended will be modest at best. One major reason is that several large tech companies front-loaded their earnings into the 1st quarter by taking years worth of a massive research tax credit in one quarter, offsetting gains on securities in the money center banks.

Analysts consistently overestimate the following year’s earnings by a wide margin. However, their estimates of a quarter just completed (but not yet reported) have been reasonably accurate since the underlying data is known. Companies have just begun reporting Q2 results. The consensus among forecasters is that ( buyback boosted ) per share earnings will be below Q1 levels and up 5% from Q2 2012 (note: Q2 2012 earnings were 5% below Q1 2012 earnings) representing a token new high ($89 vs. $88.54 five quarters ago).

Now that bond issuance has hit a wall, it is almost certain that corporate buybacks will diminish in the coming year. Who will take up the slack? A year ago it might have made sense for individuals to reallocate bond market profits into stocks, as many institutional managers did. That is no longer the case. Most individual bond purchases happened in the last year and a half, so bondholders are sitting with losses rather than profits. Further declines in bond prices might even lead institutional managers to reverse the trade and shift money out of stocks back into bonds.

Does anyone still seriously believe that the bursting of the bond bubble will lead to the great rotation by individuals out of bonds into stocks?

Aging baby boomers who just saw their “safe” investments get decimated are not about to increase their risk profile. Stocks may indeed hold up better than bonds for a while longer; at least until the existing cash in the buyback pools is expended and the bond bubble deflates. Bond prices have fallen to levels competitive with an overvalued stock market without any rotation at all.

Collateral Damage to the Real Economy

Bursting of the bubble in corporate and municipal bonds will continue to raise private sector borrowing costs and become a major drag on the economy. The mortgage refinancing business has been the largest source of bank profits (along with adjusting loan loss reserves) for the past couple of years. This rise in rates virtually destroys that sector of the economy. A steeper yield curve will boost bank profits on floating rate commercial loans over the next several years, but it is unlikely that the big boost in securities profits in the 2nd quarter will be repeated.

The big question is which force will be greater. Home sales are strong but the large price increases of the past year combined with rising mortgage rates is going to make qualifying for a loan tougher despite some moderation in lending standards. Although the housing recovery is likely to continue until the economy slows further, qualifying issues are likely to slow the pace. Although rising long-term rates create headwinds for corporate borrowers and real estate, the lack of any increase in short-term rates fails to boost income for savers and retirees.

Recent reports have trumpeted an increase in consumer spending. Unfortunately much of the increase is mirrored by the rise in non-energy imports, which does nothing for jobs and growth. Ongoing private sector job creation has boosted consumer incomes, but all of the job gains are part-time positions while full-time positions are being reduced. While welcome, the employment gains we forecasted reflect past economic growth. Employment, like inflation, is a lagging indicator that rarely predicts future economic growth. A much better predictor of future growth is savings and domestic investment in plants and equipment. Savings rates are dropping as consumers spend, while new investment languishes at low levels. Global growth restrained by both the slowdown in China and recession in Europe has resulted in a drop in US exports.

The deterioration in the trade balance also reflects the relative strength of the US dollar that has increased export prices and reduced the cost of imports. This is particularly true with regard to imports from Japan, which are rapidly rising. One result is that despite the occasional favorable data point, growth in US industrial production is trending lower.

There is one really bright point in the economy: low energy costs. A natural gas glut created by fracking technology has given the US a huge cost advantage over other developed countries, boosting economic growth. Cheap energy, not government policy is keeping the US economy growing, albeit slowly. Although low relative to global competitors, energy prices are rising (as we forecast at the beginning of the year).

The dearth of investment does not bode well long term for better US growth or inflation remaining at current low levels in the future. The combination of modest demand from an economy growing at less than 2% and imports that are restrained by both weak global growth and a relatively strong dollar preclude any short-term inflation jumps. We did not anticipate the current degree of strength in the US dollar given the combination of disappointing economic growth (which we did anticipate), and expansionary Federal Reserve policies. Inflation and inflation sensitive investments are unlikely to enter a new bull market until after the dollar turns down. The bottom line is that slow growth is the best we can hope for under any scenario and the relatively benign inflation environment is temporary.

Investment and Portfolio Tactics Now

Shortly after the financial crisis began we shifted our emphasis away from investor behavior to focusing strictly on long-term valuations. Our view was that during and following a financial meltdown, investor behavior would become unusually erratic and unpredictable. We needed to focus on strategies that had high probabilities of paying off in the long-term then tough out the short-term ups and downs in our relative performance. We believe that time has now passed (at least until the Federal Government faces a funding crisis). Both corporate and household finances are sufficiently stable to preclude them as a source of any near term financial crisis. This is not to say that serious market declines or recessions are no longer a threat. What we are saying is those events are likely to unfold in a manner where investor behavior is more predictable and useful in guiding our short-term investment decisions. Therefore we are once again incorporating these indicators in both our investments and recommendations.

Today cash and money market funds remain cheap. Real estate, precious metals, European and Japanese stocks are reasonable, while both US stocks and income-producing securities like bonds remain grossly overpriced. Although bonds and stocks now have similar valuations, bond prices have turned down while US stock prices remain firm. Based on current valuations, new investments in either US stocks or bonds make very little sense. Absent a new bubble, any potential for price appreciation is minimal while the potential for a major correction is substantial. In the current environment of low but rising interest rates, the current level of earnings requires a decline to around 1450 on the S&P before considering adding to any equity sectors that are highly correlated with the index (this excludes metals related investments and foreign equity markets).

There are very few equity sectors that continue to be supported by investor enthusiasm and are less overpriced than most other sectors. These are limited to Banking, Semiconductor, and Telecommunication companies. These are the only sectors we recommend continuing to hold on a short-term basis, but only if you already own them. Like all other sectors of the US stock market, current prices in these sectors are too high to justify any new investment. Conversely, a downturn or failure to make new highs in these sectors in the next month or so would justify exiting existing positions. Regrettably, we took profits on our positions in Banking and Telecommunications prematurely some months back, but we (and our clients) continue to own the Semiconductor sector.

International stocks in Japan and Europe represent relatively better values. A portion of our clients’ portfolios is in Japanese small cap equities at the present time. We have recently sold about 5% of portfolio out of these stocks on waning investor enthusiasm in the sector. Like the US sectors mentioned above, our ongoing ownership in the short-term is dependent on continued enthusiasm for Japanese stocks. That enthusiasm can be justified based on the rapidly improving Japanese economy and rapidly improving global competitiveness. Unlike the US focused sectors, taking profits based on short-term weakness does not preclude us from reinvesting in Japan at current prices (which represents better value than US stocks) in the near future. Similarly, European multinational companies represent much better long-term value than similar US firms. However, like Japan, those values are not sufficiently compelling in the absence of investor enthusiasm to purchase European shares at the current time. Should that change, we will consider new investment in Europe.

In our fixed income investments, our interest rate risk exposure in nearly non-existent. We exited all positions that would be significantly adversely affected by rising rates some time ago and watched patiently (but frustrated) as bond prices inflated to bubble levels. That patience paid off recently as bond prices first ratcheted lower in the last year, then plunged in the last couple of months. Our clients never enjoyed those final fleeting paper profits of the bond bubble but instead have complete liquidity and only a negligible decline from their peak valuations in their accounts. We still see no reason for new fixed income investments at current levels, other than to balance portfolios that are grossly overinvested in stocks. Money market funds and ultrashort bond funds with near zero returns are clearly a better choice than the still large potential losses in bonds and US stocks. Returns can be enhanced with small positions in non-leveraged floating-rate bank loan funds. Our clients hold such funds.

Only precious metals and related investments have been a bigger disaster than bonds in 2013. This irony was only possible because bonds were in a bubble. More often than not bonds and precious metals trade in opposite directions. After losing nearly 50% of their value from their cyclical peak, we (prematurely) invested in the Gold Mining sector. This sector is universally despised making it almost irresistible to contrarians like us. Unlike US stocks that are trading at all time highs, Gold Mining companies are trading at almost the same lows they were traded at during the depth of the financial crisis in 2009. In a world of central banks hell-bent on reflating, there exists extraordinary long-term potential in an extremely depressed, inflation-sensitive sector. That said, there is no reason to believe that prices will not first fall further. Contrary to the extreme bullishness of our long-term indicators, our short-term indicators (which turned bearish a couple of years ago) do not share that enthusiasm (although we are close after the recent rise). Given that conflict, our short-term outlook is neutral. If you, like us, own Gold Mining shares we suggest they are worth holding. If you do not own them, we would recommend postponing purchase until there is better evidence that they have bottomed.

Clyde Kendzierski

Chief Investment Officer

1Robin Goldwyn Blumenthal, Barron’s, June 8, 2013, Bottom-Line Blues: A Troubling Correlation

2Howard Silverblatt, S&P Dow Jones Indices, July 19, 2013, S&P 500 EARNINGS AND ESTIMATE REPORT

Unless otherwise indicated, investment opinions expressed in this newsletter are based on the analysis of Clyde Kendzierski, Managing Director and Chief Investment Officer of Financial Solutions Group LLC, an investment adviser registered with the California Department of Corporations. The opinions expressed in this newsletter may change without notice due to volatile market conditions. This commentary may contain forward-looking statements and FSG offers no guarantees as to the accuracy of these statements. The information and statistical data contained herein have been obtained from sources believed to be reliable but in no way are guaranteed by FSG as to accuracy or completeness. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and the author believe the information in this commentary to be accurate and reliable, however, inaccuracies may occur.

FSG provides portfolio management investment advisory services to individuals, trusts, companies and institutions. FSG manages client funds according to proprietary strategies developed by Clyde Kendzierski, Chief Investment Officer to manage his own retirement funds. Please visit www.financial-solutions-group.comto learn more about what services FSG offers.

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