[We’ve featured the sage thoughts of our friend Doug Behnfield here many times.  In the report to his clients below, the Boulder-based financial advisor reaffirms his strong conviction that Treasury bonds are still the place to be – not for yield, which stinks, but for potentially significant capital gains if interest rates should trend lower as Doug expects. RA]

As we begin the second half of the year it is remarkable how unclear the outlook is for the economy, politics and the financial markets worldwide:

*  The economy seems to be falling off the table globally, but most pundits remain confident that the central bankers (like the Fed and the European Central Bank) can somehow pull a rabbit out of the hat.

*  Obama and Romney are neck and neck in the polls. Chief Justice Roberts seems to have had some kind of stroke when presented with the latest (and perhaps last) congressional attempt at entitlement expansion. And the fiscal cliff is now moments away with no inkling of statesmanship poking its head up in Washington.

*  The financial markets have been all over the place so far this year. The S&P 500 peaked out in April after a spectacular 1st quarter and has been choppy, dropping 3.3% in the 2nd quarter. At about the same time that stocks peaked, bond yields and non-food commodities started tanking. Amazingly, analysts are still predicting double-digit earnings growth for the 2nd half of this year.

Fed Is ‘Out of Rabbits’

With all this in mind, our job is to be focused on achieving good investment returns while trying our best to avoid risk. So here is my attempt to provide clarity on how these issues translate to investment strategy and asset allocation going forward.

The central bankers really do not have any more rabbits in the hat and Ben Bernanke said as much in his most recent congressional testimony. Once they take short-term interest rates to zero, which occurred back in 2008, the remaining policy options are quite limited and fairly weak. Most of their remaining power is rhetorical, (i.e. their constant reassurance that they can fix things if they really need to). What they do not want to do is lose the confidence of the markets. Like Tinker Bell, if you stop believing, she dies. Never the less, Bernanke has made it clear that it is up to lawmakers to save the economy from recession via fiscal policy. Any more “Quantitative Easing” on the part of the Fed risks a number of negative, unintended consequences.

As most of you know, I am honestly very positive about representative democracy in America and, fiscal cliff or not, I doubt we will pull a Thelma and Louise. But to suggest that our elected officials will engineer a fiscal stimulus package in time and with enough brilliance to prevent the business cycle (i.e. recession) from showing up is just ridiculous. Elected officials have been kicking the can down the road for a very long time waiting for the political capital to attack our fiscal crisis that comes with a new presidential election cycle. What we have to look forward to, regardless of the election outcomes, are higher taxes and budget cuts. They will contribute to the economic slump rather than cushioning it or providing a push to “escape velocity” unless the mix is engineered with a minimum of polarization.

Europe Far More Dire

In Europe, the economic situation is far more dire and the political situation is chaotic. Europe, including England, is already clearly in recession and their fiscal pressures are critical. Germany is holding up better than most, but also slipping. Those who maintain that the slump in Europe will be mild or that it will have negligible impact on the U.S. economy and financial markets are disingenuous, in my opinion. The situation in Europe simply emphasizes the likelihood that we are facing a global slump, and one of potentially epic proportions. On that note, the emerging markets, particularly China and India, are experiencing stress as a result of growing weakness in the developed world and it is important to remember that these are extremely unstable political and economic regimes under any circumstances.

This leaves the financial markets. Below are three charts that compare the price of stocks (S&P 500) to the yield on 30-year Treasury bonds. The top one is a monthly chart showing the last 20 years, the middle one is a weekly chart going back 5 years and the lower one is a 2 year chart. As a reminder, the price of bonds goes up when the yield goes down. The scale on the right is interest rates, but in an effort to confuse everyone, the decimal place is wrong. The recent low at 2.6% reads 26.00. Sorry, this is the way it is quoted. The scale on the left is the price level of the S&P500. The recent high was just above 1400. Normally these two lines move pretty much together. That is because favorable economic conditions typically cause stock prices and interest rates to rise, just as weak economic conditions cause stock prices and interest rates to fall. Over the course of the last 18 months or so (since early 2011), one of these indicators seems to be getting it wrong.

Bonds ‘Wrong?’  Unlikely…

According to conventional Wall Street wisdom, the bonds (as usual) are priced wrong. Perhaps it is because there always seems to be a rationale that stocks are cheap. This time around there are several, but the most popular one revolves around the belief that bonds are expensive! It goes like this: “Why would you buy a 10-year Treasury bond yielding 1.6% when you can own blue chip, dividend paying stocks that yield 3%?” That sounds sensible on the surface. I think it is like asking “Why would you pay $3 a pound for asparagus when natural gas is going for $2.50 per MCF?” But look at the charts. Since the secular peak in stocks accompanying the Dot-Com bubble in 2000, it was the stock market that ignored the bond market at its peril. Granted, it can take a while for stocks to figure it out but when they do, they have come down hard and Wall Street has egg on their face for not recognizing the obvious.

Another feature of the charts is that in the past, bond yields were not done going down (and bond prices were not done going up) until the stock market reflected the economic weakness by getting hammered to very low levels, relative to the preceding peak.

It is reasonable to expect that bond yields have much further to drop under the assumption that we will succumb to the pressures pushing us into recession. If the 30 year Treasury Strip drops in yield by .75% from its current level of 2.92% over the course of the next 12 months, the total return would be 27%. The yield on many closed end municipal or Build America bond funds exceed 6.6%. If the yield dropped in yield by .75% as a result of a decline in prevailing interest rates rather than cuts in the distribution (dividend), the total return would approach 20%. (It is important to point out that a rise in interest rates of similar magnitude would result in a negative return on the Treasury Strip of -16%. A .75% rise in yield on the closed end bond funds would generate a 3% negative total return if it took place over one year.) I point out the total return potential because the near universal condemnation of the long end of the bond market includes the idea that “Who in their right mind would tie their money up for 30 years at 3 percent?” I have heard the same thing coming from investment strategists for at least 30 years (when rates on Treasuries exceeded 15%). We are not planning to hold long-term bonds to maturity. Buying a bond is not a prison sentence. They are an investment vehicle that is part of our overall asset allocation. In addition to delivering total return performance that exceeds that of the S&P500 over the last 30 years, the long-term Treasury bond has also been dramatically less volatile and risky. Another look at the 20 year chart shows that the decline in rates (and commensurate rise in bond prices) has taken a very smooth path compared to stocks, which resemble Mr. Toad’s Wild Ride.

Fixed-Incomes Risks

The conventional wisdom that short maturity bonds are safer than long maturity bonds for fixed income investors has simply been wrong. Fixed income investors face two offsetting risks when choosing maturities. The risk taken when investing in short-term maturities is the potential for a grinding loss of income in the event that interest rates are in secular decline. This has been the case since the early 1980s. In 1981 investors in six month CDs received a 19% interest rate. $1 million got you $190,000 in annual income. Those same investors get $2,100 at today’s rate on jumbo CDs of 0.21%. They never risked losing any principle, but the paycheck evaporated. The risk taken when investing in long-term maturities is a potential loss in portfolio market value if rates trend higher on a secular basis. Wall Street can only hope. It is a two-edged sword. Since the early 1980s, maintaining a long maturity portfolio provided the opportunity for capital appreciation that has been necessary to maintain cash flow in a declining interest rate environment. In the immortal words of Stan Salvigsen and Mike Aronstein back in 1988 when 30-year bonds paid 9% and CDs paid 8%: “The possibility of a shortage of fixed income instruments that are truly fixed for any appreciable length of time raises risks that are not generally appreciated. We have disturbing visions of packs of white-haired retirees roaming the edges of Florida golf courses with snorkels and flippers, hoping to pull a few stray balls out of the water hazards to supplement their 3 ½% CD incomes.” They should be so lucky.

When interest rates finally reach their secular lows (which may be soon), fixed income investors will finally be well advised to shorten maturities. This can be done by selling long-term bonds and investing the proceeds shorter maturities or dramatically reducing bond exposure altogether.

Investor’s Horizon Is Key

The point is, just like stocks or any other liquid investment, bond investments should be viewed with an eye toward what period represents a reasonable investment strategy horizon. An “investment horizon” refers to how far you are willing to forecast the future in terms of the way various investments and the related asset allocations will perform. Going back to the charts, extending that horizon much past three or four years is a stretch in the modern era. It may be even shorter today. In the current environment, stock prices seem to be extended and the economic growth outlook is challenging, to say the least. The deflationary forces that have been at work since the secular credit expansion peaked in 2007 have yet to be exhausted. A return to recession, particularly one of global proportions, would cause deflation (especially in asset prices such as stocks and real estate) to resume and interest rates on high quality, long-term bonds to continue their secular decline. I find it difficult to make a reasonable case that the bond market has gotten the economic outlook wrong. If that were the case however, then bond yields would need to rise to meet the hopeful outlook reflected in current stock prices.

What does make sense to me is that stock prices have recently embarked on a cyclical decline that could be nasty enough to result in values achieving conventional bear market levels that are “cheap”. In the process bond yields will continue to decline, providing further capital appreciation that will make it appropriate to shift our asset allocation away from the defensiveness of long bonds and more toward the opportunities that stocks offer in the growth outlook that will inevitably emerge.

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