As the Dow Jones Industrial Average soared beyond 15,000 recently, investors are engaging in a heated debate about the longevity of the bull market in stocks — now more than four years old and counting.
But don’t lose track of the other bull market that has been marching higher for much longer … the long-term bull market in bonds.
That’s because the fate of the great bond bull market could play a key role in the outcome for stocks.
Many investment pros have warned repeatedly about the imminent demise of Treasury bonds. The Fed’s relentless quantitative easing, plus a soft global economy, conspired to drive interest rates to record lows — while Treasury bond prices move in the opposite direction to new highs.
From such a low level it is reasoned, bond yields have nowhere to go but back up, and a bond market crash will be the inevitable result.
|The great bond bull market may be over, but the bond bulls don’t know it yet.|
At Berkshire Hathaway’s annual shareholder meeting recently, Warren Buffett pitied poor fixed income investors for the skimpy yields they must accept. He declared America’s savers are “victims” of the Federal Reserve’s monetary policies to lower interest rates.
Even the “bond king” Bill Gross of PIMCO — the man at the helm of the world’s biggest fixed income mutual fund — said the three-decade long bull market in bonds is over.
But rumors of the bond market’s demise may be somewhat exaggerated.
Stocks and Bonds Pull Investors in Opposite Directions
Stocks and bonds have enjoyed sizeable gains in recent years. The Dow is up more than 160 percent since it bottomed below 7,000 in 2009. And the Barclays U.S. Aggregate Bond Index, a fixed income benchmark not known for posting big capital gains, is up about 30 percent over the last five years.
Could this mean that both stock and bond investors are living on borrowed time?
The Dow above 15,000 is telegraphing a stronger global economy and growing corporate profits ahead — a bullish scenario for stocks. This is the re-flation signal from the stock market … perhaps leading to inflation in the not-too-distant future.
Meanwhile, the bond market is sending a mixed signal because ultra-low yields are indicating deflation, or at least very slow-growth conditions persisting as far as the eye can see. As a thought-provoking article in The Wall Street Journal recently explained, the mixed signals coming from stocks and bonds “can’t both be right … they could both be wrong.”
These are indeed tricky times for investors, because ultimately getting this call right has very important implications for your personal asset allocation, not just for the next few years, but perhaps over the next decade.
Or as the article goes on to point out: “For the first time in 50 years, U.S. investors in a balanced portfolio of stocks and bonds face the near-certainty that they will lose money on a large chunk of their investments, after accounting for inflation — and a significant risk that they will lose money on all of them.”
Fed in the Eye of the Storm
The Federal Reserve is entirely to blame for this dilemma. The Fed’s latest round of QE, an open-ended $85 billion per month bond buying spree, is a relentless attempt to push down yields and punish savers in the process. But savers and investors large and small are responding as expected. After four long years of QE, investors take Ben Bernanke at his word that rates will remain low, perhaps longer.
After inflation, the benchmark 10-year Treasury yields just 0.91 percent … and that’s based on the government’s flawed measure of inflation. Bear in mind that the average yield on 10-year Treasuries since 1990 has been more like 5 percent, proving just how unappealing bonds are as a long-term investment.
And Treasury inflation-protected bonds (TIPS) are so expensive today that in many cases they practically guarantee you’ll lose purchasing power over the 10-year life of the bond.
Meanwhile, even at today’s lofty levels the dividend yield on the S&P 500 stock index is 2.1 percent, a rare occurrence when stock yields trump bond yields for the first time in 50 years. Additionally, stocks offer some built-in protections against future inflation …
First, the prospect of increased dividends over the next decade, unlike the fixed interest paid by Treasury bonds, can help investors stay a step ahead of inflation. Growing dividends are also an important component in a stock’s total return, that’s often overlooked.
Second, the revenue and income stream from stocks can increase along with inflation, as companies simply raise prices to keep up. But don’t expect the U.S. Treasury to retroactively increase the interest rate it pays on bonds issued today.
As you may have guessed, my personal opinion falls squarely in the inflationist camp, eventually stocks will win out in this tug-o-war with bonds, but correctly picking that inflection point is tricky business. For the time being, Treasury bonds remain locked in a trading range, with a floor near 2.7 percent, and a ceiling of 3.5 percent (currently 3.15 percent).
Bond prices and yields have been fluctuating through this zone of support and resistance for several years now, as shown in the chart above. The great bond bull market may be over, as the bond king says, but the bond bulls don’t know it yet. So the trading range could continue awhile longer.
I’m betting on a breach in Treasury bond yields to the upside, which inevitably means a breakdown in bond prices. One way to play this trading range, and the inevitable breakdown, is the ProShares Ultra Short 20+ Year Treasury Bond (TBT). This ETF is meant to rise 2 percent for each 1 percent drop in long-term Treasury bond prices.