The Long Bond Secular Bull Market is Over
(April 13, 2006)
Dear Subscribers and Readers,
This author would like to start this commentary by coming out swing: There is a very good chance that we have seen the bottom of long-term yields for this cycle when the yield of the 30-year Treasuries touched a low of 4.16% on an intraday basis on June 13, 2003. I have discussed the action (and made predictions) on the long bond in many of our commentaries over the last 12 months. In fact, my first major article on the long bond was our March 27, 2005 commentary (just slightly over a year ago) entitled “Rising Rates Not a Given.” At the time, the sentiment in the long bond was very bearish – in light of a higher-than-expected CPI reading and the perception that the Chinese and the Japanese governments were going to dump U.S. Treasuries at a moment's notice. In our March 27, 2005 commentary, I stated the following about the long bond:
For the foreseeable future, foreign countries such as Japan and China have no interest in dumping U.S. Treasuries – as they continue their mercantilist policy to suppress the value of their respective currencies. As a matter of fact, the United Kingdom has been a huge purchaser of U.S. Treasuries during 2004. From January 2004 to January 2005, the United Kingdom's holdings of U.S. Treasuries increased from $91.8 billion to $163 billion – an increase of over 77%! The combined actions of the U.S. dollar and the Central Banks around the world over the last few years further convinces me that these holdings will increase further as the U.S. dollar continues to decline. Unless the Asian consumer markets can develop at an exponential rate over the next five years (in which case a higher Chinese Renminbi will not matter to the Chinese producers/exporters), this continues to be the high probability scenario.
Given that the market for Treasuries is more or less a fictitious market and thus is not really a reflection of inflationary expectations, the yield of the 30-year Treasuries, for example, is now solely dependent on the actions of foreign governments, hedge funds, and institutional investors. Given the recent CPI report, however, it is now natural to be bearish on bonds. As Mr. Mark Hulbert of Marketwatch.com says in his March 23rd “The lonely contrarian” article, however, this trade is just too easy. I will now quote the relevant paragraphs from that article:
As of Tuesday night's close, the HBNSI stood at negative 56.8 percent. The negative reading means that the average bond timer in this index is short the bond market. In fact, the current level equals this index's all-time low. Never in the years of our tracking this group of bond timing newsletters have they been more bearish than they are now.
In contrast, the gold timers are extremely bullish: As of Tuesday night, the HGNSI stood at 71.4 percent. That's within shouting distance of this index's all-time high reading of 89.6 percent.
From the point of view of contrarian analysis, these readings suggest that bonds are more likely to go up than down over the short term -- and that gold will do the opposite.
Over the past four years, for example, the HBNSI has dropped to this low a level just five times. Within the weeks following each of those occasions, the bond market staged a significant rally.
The most recent occasion on which the HBNSI was this low was last May 14, nearly a year ago. Over the subsequent four months, the government's 30-year Treasury bond rose by 10 percent.
Mr. Hulbert then goes on to hedge himself, however, as he states that sentiment isn't the only thing when it comes to forecasting future prices. I agree with Mark on this one – but the extremely bearish reading on the HBNSI definitely says a lot and is a huge warning to bond bears. The bearish sentiment in bonds is further confirmed by the relatively low level of assets in the Rydex Government Bond Fund – a level that has not been this low since December of last year.
At the close on March 24, 2005, the yield of the 30-year Treasury bond stood at 4.84%. Over the subsequent two months, it would hit a low of 4.20% on a closing basis.
In subsequent commentaries and finally in our March 12, 2006 commentary (“Rising Rates Now a Given”), I discussed the many popular reasons which have been cited for a strong domestic bond market, including DB pension fund liability matching (pension funds investing in long-dated bonds in lieu of equities in order for their assets to better “match” their pension liabilities), both Japan's and China's mercantilist policy of putting a lid on the value of their currencies (which interestingly does not explain why yields on the Euro markets have gone down much more than the domestic bond market), and finally, the fact that many hedge funds and investment banks have been shorting the long bond and were subsequently forced to cover their short positions – thus further driving down the yield of the long bond.
By far – however – the most important pillar of support for the long bond over the last five years was the “quantitative easing” policy adopted by the Bank of Japan in order to flood the Japanese banking system and economy with lots of liquidity. In our March 12, 2006 commentary, I stated: “These funds [via the “quantitative easing” policy] were mainly injected via the purchase of government and commercial securities by the Bank of Japan. At the same time, the Bank of Japan bought approximately 1.2 trillion Yen worth of government bonds every month – including long-term (10-year) Japanese government bonds. This had the significant effect of capping domestic yields at the long-end and lowering yields all across the Japanese yield curve, with the 10-year yield falling to 0.53% by the end of May 2003 (even though Japan's sovereign rating is rated lower than Botswana's by S&P and Moody's). For readers who recall Ben Bernanke's anti-deflation (“dropping money from helicopters”) speech in 2002, what the Japanese government and the Bank of Japan did over the last five years with their “quantitative easing” policy came as close to “dropping money from helicopters” as any developed country has gotten since the end of World War II. It is interesting to note that all the Austrian economists had a field day with Bernanke's 2002 anti-deflation speech, and yet most of them had no idea that the Japanese had been doing this very precise thing since March 2001.” Japanese private investors and pension funds (by far the largest creditor group in the globe) subsequently started to play the game of “the search for yield” – thus having the effect of compressing bond yields and bond spreads around the world. Case in point: Since March 2001, the correlation of the monthly movements of the Japanese 10-year government bond and the U.S. 10-year Treasury bond has reached 70%!
Since our March 12, 2006 commentary, the yield of the 30-year Treasury bond has risen from 4.74% to 5.05%. More importantly, the gradual phasing out and ultimately, the end of Japan's quantitative easing policy will remove a huge pillar of support for both U.S. Treasuries and for European sovereign bonds.
Another indicator which is telling me that long bonds have most probably topped out is this: The tide of sentiment seems to be turning. During March 2005, everyone were worried about foreigners dumping U.S. Treasuries – this extremely bearish sentiment was also reflected in Mark Hulbert's HBNSI as well as the increasing inflows to the Rydex Juno Fund (an index fund which trades at an inverse to U.S. long-dated government bonds). Since early 2005, our current account deficit has continued to deteriorate – and more worryingly, the budget deficit for the fiscal year of 2006 (which ends September 30th) is projected to reach $371 billion, or 2.8% of U.S. GDP. Just like the hot IPOs and ever-increasingly insider selling of technology stocks in the late 1990s, increasing supply of a particular asset class does not necessarily matter – until it does. The continuation and reinforcement of a bullish trend usually makes market participants complacent – and complacency always precedes the end of the trend and the subsequent fall. At the end of 2005, the national debt stood at $8.17 trillion. As of the evening of April 11th, this has reached a record $8.41 trillion – an increase of $240 billion within a little over three months. The fact that many investors are not worried even in the face of an ever-rising current deficit and budget deficit is starting to worry this author quite a bit.
Okay, Henry, the national debt of the U.S. has essentially been increasing exponentially since the late 1950s. Sure, there was a huge loss of confidence from the mid 1970s to 1982, but apart from that “spike” in interest rates, both domestic and foreign investors have had no trouble in “digesting” our government debt. The game was stretched even further with the mercantilist policy of both the Japanese and Chinese governments in recent years, along with “the search for yield” coming from Japanese private investors and the “coercion” of both U.S. and European pension funds into investing in long-dated government bonds in order to better “match” their liabilities. So the $64 million question is this: Will demand continue to indefinitely outpace supply – given that supply is still exponentially increasing – not only on an absolute basis but also relative to other economic indicators such as GDP and U.S. household assets? Will foreigners continue to accrue U.S. Treasuries at their current pace – with the Chinese and Indians “replacing” Japanese private investors given that Japan is projected to start running a current account deficit as early as five years from now? My answer is a “no,” and I will try to further quantify this to our readers in this weekend's commentary. In fact, this author is going to put his own name on the line by releasing a press release about this sometime next week as well. Readers please stay tuned.
On Coca-Cola (KO)
I would now like to use the rest of this space to discuss an assortment of things – starting with Bill's commentary last week about Coca-Cola. As readers should know, Bill is a little bit more bearish on KO than I am – as I had suggested that KO starts to offer a “more compelling” valuation at a price of $25 to $30 a share – given its relatively high dividend yield and high cash flows. This price range is usually much lower than the “fair value” as published by major publications such as The Motley Fool or Morningstar – whose estimates usually range in the $45 to $55 a share area. So what is causing the difference between our valuation of KO relative to valuations from other publications? When valuing a company such as KO, publications like The Motley Fool and Morningstar tend to give KO a very low discount rate in their DCF models (9.5% cost of capital vs. 11.5% which Bill used), as KO has historically had a very stable model and a very good brand name. This would also give KO a P/E of 20 – which is also fair in this relatively low interest rate environment. Both set of valuation conditions, however, do not offer a very compelling value for KO. Remember: Buffett accumulated his shares in 1988 at a P/E of 13 – and with a lot of bearish sentiment to boot. Many analysts in 1988 were openly questioning the integrity of acquiring so many shares of KO at “such a high P/E.” In contrast, even though the secular bull market in KO ended in 1998, investors' sentiment towards KO today is still relatively bullish. Sure, Pepsi has just surpassed KO in market capitalization, but bulls will continue to argue about KO's brand value – while still assuming exponential growth in emerging markets such as Brazil, China, and India. Even the bears will concede that there is still a lot of growth left internationally.
No, this author will only buy KO once it gets to be psychologically difficult to buy. That is, I will only buy KO when the WSJ and retail investors are discounting a secular decline in the carbonated drinks market, as well as highlighting the faults with their ownership system of the bottlers (which Bill had mentioned in his commentary). Interestingly, many of the mainstream analysts have acknowledged the inherent flaws of such an ownership system – but most of them have never taken this into account in their valuation models. Finally – given KO's relatively high dividend yield and lack of organic growth, the common stock of KO is starting to trade more like a bond – and given the prospect of a secular rise in interest rates going forward, there is still a lot of room for KO to continue to fall.
On “Denial” and GM
The human race as a whole tends to be generally optimistic – and we also tend to ignore problems until it is too late. We also like to shift blame to other parties when something goes wrong – such as blaming one's losses on an investment to incompetent management or a change in the investment environment – when one could have picked this up by just studying the financials and biographies of management or by studying macroeconomic trends. Speaking of denial, a classic example involved the planned German invasion of Belgium in 1940 – when copies of Hitler's original plans to invade Belgium, Holland, and France were impounded by the Belgian police. In his memoirs on World War II, Winston Churchill wrote: “On January 19 … A German staff-major of the 7th Air Division had been ordered to take some documents to Headquarters in Cologne. Wishing to save time for private indulgences, he decided to fly across the intervening Belgian territory. His machine made a forced landing; the Belgian police arrested him and impounded his papers, which he tried desperately to destroy. These contained the entire and actual scheme for the invasion of Belgium, Holland, and France on which Hitler had resolved … I was told about all this at the time, and it seemed to me incredible that the Belgians would not make a plan to invite us in. But they did nothing about it. It was argued in all three countries concerned that probably it was a plant. But this could not be true. There could be no sense in the Germans trying to make the Belgians believe that they were going to attack them in the near future. This might make them do the very last thing the Germans wanted, namely, make a plan with the French and the British Armies to come forward privily and quickly one fine night. I, therefore, believed in the impending attack. But such questionings found no place in the thought of the Belgian King, and he and his Army Staff merely waited, hoping that all would turn out well. In spike of all the German major's papers, no fresh action of any kind was taken by the Allies or the threatened states. Hitler, on the other hand, as we now know, summoned Goering to his presence, and on being told that the captured papers were in fact the complete plans for invasion, ordered, after venting his anger, new variants to be prepared.”
That so many sovereign countries and statesmen (it is to be noted that Churchill was not Prime Minister of Great Britain at that point just yet) engaged in the same dangerous game of denial and false hopes during such a dark time for modern civilization certainly does make one think. For example, how easy is it for central bankers today to take the benign world economic environment today and project this scenario into the indefinite future? Such “Pollyanna” thinking was certainly the norm during the exciting days in late 1999 and early 2000. In fact, GM has had the same mentality at least for the last 30 years or so. In yesterday's interview on CNBC, Bob Lutz, Vice Chairman of Global Product Development, when asked about a possible strike at Delphi, responded: "We just absolutely refuse to believe that there's going to be a strike … We're gonna work our way through it … None of the three parties would benefit from a strike, not the UAW, not Delphi, not General Motors." According to the WSJ, he also backed current CEO Rick Wagoner, stating: "He is without question the right man to lead General Motors. Read my lips, Rick will preside over the turnaround … Rick Wagoner will be the celebrated hero."
Like I said before, it is very difficult to imagine how the folks that got GM into this mess in the first place can take the company out of it – especially given its total dependency on non-hybrid SUVs in the midst of $3 gasoline prices, rising material prices, and rising interest rates. Moreover, its bonds are now trading at 60 cents on the dollar – and they would definitely be trading significantly lower if it were not for the existence of credit default swaps that would insure GM bond investors against a GM bankruptcy. Finally, Vice Chairman Lutz is also blaming the latest drop in GM common on short-sellers – which is either a sign of total denial or desperation (or perhaps both). Actually, if it were not for the relatively high dividend yield, GM common would definitely be trading significantly lower today.
It is said that the best investments are investments which will make you money when you are right but which won't lose money if you're wrong. In the current scenario, the shorting the homebuilders may actually fit this bill – as investors are still discounting rosy conditions even in the midst of a slowdown in the residential market – all within a backdrop of rising rates, rising material prices, rising labor prices, and the rising costs of acquiring new plots of land. Even if the secular bull market in housing is still well and alive (which is not very likely given the high probability of a secular rise in interest rates going forward), probability still suggests at least a “mid-cycle slowdown” scenario – as outlined in the following chart (updated to March 2006) comparing the current action in the homebuilders vs. past bull markets in gold, the Nikkei, and the NASDAQ Composite:
In other words, the stock prices of homebuilders still have significant downside even if we are “only” in a mid-cycle slowdown scenario. Moreover, the bearish sentiment in homebuilders is not as extreme as they have been in the past, as the short interest in the biggest homebuilders such as PHM, KBH, and TOL are actually close to 12-month lows.
Henry K. To, CFA