Lance Roberts | Oct 27, 2020 07:27AM ET
Here we go again. After plunging to new lows, the calls for the end of the “bond bull” market mount each time rates rise. Is this time the end of the “bond bull?” Or, is there another huge bond-buying opportunity to come?
We recently reduced our exposure to bonds, the first time in years, due to the more extreme overbought condition of Treasury bonds following the pandemic’s onset. The long-term chart of yields below shows this to be the case.
There are two critical points to take away from the chart above.
There are currently two significant risks from rising interest rates, which investors should heed.
h3 Valuation Expansion/h3One of the primary themes used by the “Permabulls” is that “valuations are cheap due to low interest rates.” That argument has been the clarion call of a generation of investors who have ignored fundamentals and valuations to chase market returns.
Since 2019, when earnings growth began to deteriorate in earnest, investors bid up shares. As such, the primary driver of returns, as shown below, has come from “multiple expansion.”
The “hope” remains that earnings growth will eventually catch up with valuations. However, despite being 3/4ths of the way through 2020, the outlook for earnings continues to deteriorate. In just the last 15-days, the estimates for 2021 have declined by almost $7 per share despite repeated statements of a recovering economy.
There are two problems with the thesis that “low rates justify high valuations.”
However, since stock prices reflect economic growth, the impact of rising rates on the economy is a far more significant issue.
h3 The Debt Problem/h3People don’t buy houses or cars. They buy payments. Payments are a function of interest rates, and when interest rates rise sharply, mortgage activity falls as payments rise above expectations. In an economy where roughly 70% of Americans have little or no savings, an adjustment higher in payments significantly impacts consumption.
I could go on, but you get the idea as we discussed concerning debt-to-income ratios:
h3“Such is also why interest rates CAN NOT rise by very much without triggering a debt-related crisis. The chart below is the interest service ratio on total consumer debt. (The graph is exceptionally optimistic as it assumes all consumer debt benchmarks to the 10-year treasury rate.) While the media proclaims consumers are in great shape because interest service is low, it only takes small increases in rates to trigger a ‘recession’ or ‘crisis’ event.”
Am I saying rates can’t rise at all?
Absolutely not. However, there is a limit before it negatively impacts the economy, and ultimately the stock market.
h3 Bond Prices Very Overbought/h3In June of 2013, when the cries of the “death of the bond bull market” were rampant, I made repeated calls that then was an ideal time to be a “buyer” of bonds.
“However, the recent spike in interest rates has certainly caught everyone’s attention and begs the question is whether the 30-year bond bull market has indeed seen its inevitable end. I do not think this is the case and, from a portfolio management perspective, I believe this is a prime opportunity to increase fixed income holdings in portfolios.”
As shown in the chart below, that was the correct call and, despite repeated wrong calls by the mainstream analysts, bonds remained in an ongoing bullish trend.
Since interest rates are the inverse of bond prices, we can look at a long-term chart of rates to determine when bonds are overbought or oversold.
In 2019, rates began to slide slower as the realization that economic growth was weakening weighed on outlooks. As the yield curve began to invert, the Federal Reserve stepped in with expanded “repo” operations to shore up financial institutions.
Rates kept going lower.
In March of 2020, the economy was shut down due to the pandemic causing rates to plunge to record lows.
h3 Huge Bond Buying Opportunity Coming/h3The plunge in rates and massive Fed liquidity caused stocks to surge to new highs despite an underlying recessionary economy.
Currently, the plunge in interest rates pushed bonds to an extreme “overbought” condition.
Such suggests the most likely target for rates in the near term could be as high as 2.0%. While an increase of 1.2% from current levels doesn’t sound like much, that increase would push bonds back to “oversold.” That move will provide the best opportunity to increase bond exposure in portfolios.
We can confirm the same using a very long-term chart (50-years) of 10-year interest rates overlaid with a 10-year moving average. As you can see, that moving average has provided formidable resistance and denoted every peak in rates going back to 1988.
Currently, with interest rates at the bottom of their long-term trend, the risk is that rates could indeed rise in the months ahead.
What could cause such an increase in rates?
These lead to concerns over temporary inflationary spikes, which could drive interest rates back to the top of the long-term downtrend.
h3 Where To Invest While We Wait For Bonds/h3While bond prices currently remain overbought, such a condition will likely not last very long. As shown below, markets and volatility have an inverse relationship with rates, hence the non-correlation for portfolios. The long-term log-chart of interest rates and the stock market tells the tale.
This analysis also suggests that the correction that started in March is likely not over as of yet in the longer term. If rates rise back toward the long-term downtrend, bond prices will come under pressure as the stock market corrects.
For investors, we can turn to our colleague Jeffrey Marcus of TPA Analytics. He recently analyzed the best places to invest during rising interest rates:
“The 4 best performing sectors are:
- Technology
- Consumer Discretionary
- Industrials
- Materials
The 4 worst performing sectors are:
- Utilities
- Telecomm
- REIT’s
- Staples
The 2 best performing broad categories are:
- Small-Cap Growth
Small-CapThe 2 worst performing sectors are:
- Large-Cap Value
Large-CapCommodities: Crude and Copper are positive over half the time. Crude is the best performing commodity, historically.
Gold is the worst-performing commodity; it is only positive 14% of the time.
2 more focus items:
- TECH beat the S&P500 100% of the time
- Utilities underperformed the S&P500 100% of the time”
In the short term, we have cut our bond exposure and have begun to shift our allocations to protect portfolios for a rise in interest rates.
However, as rates rise within their technical downtrend, the media will be replete with headlines about the death of the 40-year “bond bull market.”
It won’t be.
While in the very short-term, the current overbought condition suggests we could see more downside pressure in bonds over the next few months. Such would not be surprising.
However, as we approach that point where the market begins to realize the impact of higher rates on economic growth and corporate profitability, bonds will again emerge as a haven for investors against market declines.
In an economy that is $75 Trillion in debt, requires $5.50 of debt per $1 of growth, and running a $3 Trillion deficit, rates can’t rise much.
Which is also why the Federal Reserve is now forever trapped at zero.
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