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At Secure Retirement, one of our key investment rules is to avoid all
“bubbles.” Whenever any market becomes clearly overpriced, we will leave
that market.
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Economic & Market Update, September 2010
The Great Bond Bubble?
by Richard Morey
At Secure Retirement, one of our key
investment rules is to avoid all “bubbles.” Whenever any market becomes
clearly overpriced, we will leave that market. For example, in 2005 we
sold the real estate-related investments (real estate investment trusts
or REITS) we held for our clients. Our astute readers will note that
this move was made well over a year before real estate started to go
down. In other words, we would have made more money had we waited. In
fact, the last year of a bubble is often the year prices rise the most,
as by then investors are convinced the market in question will go up
forever. When the market is at its highest point, they throw the last
vestige of caution to the wind and buy more. As a result, bubbles
almost always last one to two years longer than any rational investor
would expect. Butsince they usually go down very quickly once they pop,
I try to consciously “error” on the side of safety by leaving a
dramatically overpriced market before the losses begin
Another
example of how we deal with bubbles involves the Chinese real estate
market that is now abubble – even according to their own Government. In
early 2009 we bought Third Avenue Value, which is over 50% in large
commercial real estate in Hong Kong. It went up 44% last year, but we
sold it before year’s end – even though the bubble continued to grow.
Again, not knowing exactly when that(or any other) bubble will pop, we
would much rather sell a bit early than greedily hold on to try to grab
the last penny before the music stops.
Given these
facts, I surprised myself when I realized I was going to write an
article this month defendingan investment – in this case U.S.
Government bonds – that many are now calling a bubble. Bonds areone of
the least understood markets, and I am continually amazed at how little
supposed financial“experts” know about this important topic. For
example, an analyst named Jeremy Schwartz, the directorof research at a
company called WisdomTree, recently spoke on Bloomberg television.
Schwartz (alongwith Jeremy Seigel) had just published an op-ed piece in
the Wall Street Journal entitled "The Great American Bond Bubble.”
Schwartz said that 10-year U.S. Government bonds are being priced
liketechnology stocks that sold for over 100 times earnings at the peak
of the Internet bubble. Afterexplaining why he thinks bonds are as
overpriced today as Internet stocks were back in 2000, he and the
Bloomberg host then gasped at the financial devastation this is sure to
bring to bond investors.
After laughing out loud, I
became concerned that investors who own U.S. Government bonds would
believe such nonsense. Here is why their hysteria makes no sense:
First, people who own U.S. Government bonds are guaranteed to get their
principal back. As a result, even if they are a bubble, and even if
their prices plunged for some time, when the bonds mature investors are
guaranteed to get 100%of their money back. These bonds are issued at a
price of 100 and paid back at a price of 100, no matterwhat happens
along the way. Even though I assume Schwartz, Siegel, Bloomberg and the
Wall StreetJournal are aware of this fact, they led their listeners and
readers to believe that a security with guaranteed principal is as
risky as Internet stocks, many of which lost 100% of their principal
when the Internet bubble burst in 2000.
This does
not mean bond investing is without risk, but stock market risk dwarfs
the risk of owning U.S. Government bonds. At Secure Retirement, I focus
upon bond market risks, and opportunities, every day. At the beginning
of the year I was sure we would experience more economic disturbances
that would send the prices of U.S. Government bonds higher. So far this
year the intermediate term bonds owned in our funds have made our
clients an extra 7%+ from increases in their prices. But do these price
gains constitute a bubble? To answer this question we need to look
beyond prices alone to see why they have gone up and whether or not
these causes still exist.
It isn’t hard to figure
out why U.S. Government bonds have gone up in price, since one factor
accountsfor almost all of their movement. This factor is interest
rates. Bond prices go up when interest rates go down, and they go down
when rates go up. At the beginning of the year 10-year U.S. Government
bonds(officially called 10-Year Treasury Notes) were paying interest of
3.8%. By late August the yield had fallen to 2.5%, which is a 34%
decrease. As a result, their prices have gone up.
But
while the prices of these bonds has gone up, they are only overpriced
and poised to go down if theFederal Reserve Board plans to raise
interest rates in the foreseeable future. Fortunately, it is not hard
to determine if this is going to happen, because Fed Chairman Bernanke
has clearly stated that they do notintend to raise rates for an
extended time period. The Fed raises rates when the economy starts to
growtoo quickly, overheating into inflation. Does anyone actually
believe the U.S. economy is growing too fast today?
Since
it is almost impossible for these bonds to go down significantly
without rising interest rates, wecan say with some confidence that U.S.
Government bond prices are safe until further notice. In fact,
atpresent there is a good chance their prices will continue to go up.
If the economy continues to weaken, the Federal Reserve Board will
continue to do whatever it can to lower interest rates further. While
theycan’t lower short-term rates much, as they are already near 0%, the
Fed is planning to buy more longer-term Government bonds. This can
lower interest rates, driving the prices of bonds higher. Plus, if
theworld economy should suffer any more shocks, investors will continue
to seek the safety of U.S. Government bonds, again driving their prices
higher.
Another point to keep in mind is the fact
that bond markets typically move much, much slower than stock markets.
If bond prices do get to the point where they are too high (i.e. the
economy is firing on allcylinders such that the Fed is getting ready to
raise interest rates), we will have several months to spotthe
phenomenon and sell them before they have gone down more than a few
percent in price. And even those losses will be offset by their
interest payments. That’s quite a bit different from the risk that
hitsinvestors when the stock market becomes a bubble and then bursts,
in which case it can lose 30% ormore in a few months.
There
is one final trick the bond market naysayers are using to try to scare
investors. They say there isno way that buying a 10 year bond paying
2.5% in interest (or a 30 year bond paying 4%) can be a good
investment. I believe they would be correct if a person was required to
hold the bonds for the entire 10 years. I certainly hope and believe
our economy will have solid growth long before another 10 yearspasses,
in which case interest rates should go up such that a 2.5% rate won’t
look very good. However, I would be surprised to see the economy really
taking off before the end of next year. But wheneverinterest rates look
like they will be rising we are indeed allowed to sell the bonds that
will negatively affected.
While I am not concerned
that we now have a dangerous “bond bubble” getting ready to burst, this
doesnot mean we would buy many more Government bonds today. In fact,
several of our fund managers have recently begun to sell some of their
U.S. Government bonds that have gone up the most in price. But they
will most likely reduce their holdings in these bonds over time. They
are taking advantage ofhigh prices to make some sales, but for all the
reasons discussed above they are certainly not afraid. Instead, like me
they are quite pleased with the profits they have continued to make for
our clients.
So while I am not concerned about
bonds in the near-term, there are two scenarios that would be
trulydamaging to bond prices. At some point in the next few years there
is a chance that our Government’sescalating debts will end up leading
to a serious bout of inflation and/or a large drop in the value of
ourcurrency. Either of these would lead to losses in the majority of
assets denominated in the U.S. dollar, including nearly all bonds.
Inflation destroys retirement plans, and as soon as it begins to loom
on the horizon we will indeed sellmany of the bonds we currently own,
replacing them with inflation-protected bonds and related assetsthat go
up in price during inflationary times. But at this time deflation may
be a bigger worry than inflation. Plus, we will have plenty of time to
restructure our portfolios to protect against this risk, asinflation
builds over many months.
On the other hand, the risk of having the U.S. dollar collapse, i.e.
plummet in value versus foreign currencies, is something that can
happen very quickly. I have been concerned about this possibility
forseveral years, and these concerns are increasing. I am concerned
that the Federal Reserve Board’sdecision to flood the world with even
more dollars (through more and more bond purchases) to fund ourhuge and
growing deficits and lower interest rates could backfire and destroy
the value of the dollar in short order. This is the one bond market
risk that worries me right now. To protect our clients againstthis
risk, at the first hint of a dollar collapse we (and/or our bond fund
managers) will sell many of thebonds we own now, putting the money into
cash. Then if it really looks as if our currency is going to crash we
would most likely reinvest much of the money into Government bonds
issued by foreign countries. This is a sure way to protect against a
falling dollar, for foreign currencies and bonds as awhole will go up
basically the same amount the dollar goes down, while certain foreign
currencies and bonds will rise dramatically.
If I made this sound easy, I was mistaken. In a real currency crash we
would have perhaps only a fewdays to spot it and take dramatic
protective action. Still, while I am confident our accounts would hold
up through a currency crisis, I really hope I never get a chance to
prove this!
In summary, until the economy is strong and the major risks are clearly
behind us, I will continue to believe that owning the safest
investments is a prudent course to follow. Our clients made
approximately10% in the first eight months of this year from the U.S.
Government bonds owned in our funds (7% in price gains and 3% in
interest). Some day we will change our conservative stance of being
overweight in the safest investments and underweight in stocks, but
that day has not yet arrived.
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Quotable Quotes
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If business does well,
the stock eventually follows - Warren Buffett
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Talking
about the value of experience Mr.Buffett said, "Can you really explain
to a fish what it's like to walk on land? One day on land is worth a
thousand years of talking about it, and one day running a business has
exactly the same kind of value."
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