Here’s Why The Long Bond Could Be About To Blast Off

I always love hearing people say things like, “interest rates are so low they can’t go any lower!” That’s the sort of superficial thinking that gets investors into trouble and provides opportunities for those willing to look a bit deeper.

So let’s take a look and see if that’s actually true – that rates are as low as possible right now. Taking a quick look around the world at other developed nations it’s pretty plain to see that our bonds, even at a meager 2.3%, offer pretty incredible relative value:


The UK is paying a fairly comparable 2%. But Germany pays less than 0.8% and Japan’s minuscule yield is hardly worth mentioning. In fact, borrowing for next to nothing in Yen and then converting to dollars and purchasing long bonds (called a “carry trade”) has been a “no-brainer” (another kind of thinking that can get investors into trouble) for a long time now.

The question that comes to my mind when I look at this chart is, “why couldn’t our rates go as low as the UK, or Germany, or even Japan?” Maybe I’m just not imaginative enough but I can’t think of a bulletproof reason our rates should find a floor at current levels.

What’s probably even more important to consider is the fact that the Fed’s Quantitative Easing activities have dramatically reduced the supply of these bonds and because they are reinvesting the proceeds of maturing bonds that will remain the case for quite some time. And what happens when you dramatically reduce supply while demand holds fairly steady? That’s right! The price goes up. This isn’t rocket science, folks.

Then consider the fact that demand has been muted because portfolio managers (and individual investors) have absolutely hated these things for at least the past year. They haven’t been this underweight since 2007 right before long bonds went on an epic 50% run over 18 months:

BAML Bonds Nov 14

Chart via Fat Pitch

I’ll remind you that long bonds have been the best performing asset class so far in 2014 despite this meager demand from portfolio managers. It’s pretty amazing to consider that they still consider them their favorite short idea:

iiKhZBiGSMpIChart via Bloomberg

Imagine how they’ll do if portfolio managers and individual investors decide rates aren’t going higher any time soon and so they shouldn’t hate/short them anymore. Not to mention the potential for a “flight to safety” out of high-yield, leveraged loans or even stocks. Ultimately, I can see the distinct possibility of a real blowoff type of move at some point.

And wouldn’t that be the most fitting way for this epic bull run to end?


See also: “The $400 Billion Bond Mismatch Keeping Bears at Bay” -Bloomberg


A Conversation

Imagine a financial adviser* approached you with an investment opportunity** without telling you specifically what it was. And right up front he tells you it’s likely to generate a zero to negative return over the coming decade. What would you say?

I imagine any investor with any common sense would respond by saying something like, “why in hell would I want to own something that will generate a zero to negative return over 10 years?!

And the adviser would likely respond with: “Well the outlook for other asset classes over the next 10 years is no more attractive than it is for this one.”

Common sense investor: “Well if it’s going to return zero or less wouldn’t even a savings account do better? Why not just own safe fixed income instruments? We can ladder them so we don’t have too much interest rate risk or opportunity cost. And it’s plain to see that plenty of asset classes offer returns better than zero over the coming decade. Why not just own them?”

Adviser: “There seems a reasonable likelihood that inflation will accelerate at some point over the next decade, and this asset class is a good hedge against inflation.”

Investor: “Okay. If runaway inflation is the only reason to own it wouldn’t TIPS or precious metals provide a better hedge considering this asset class’s extremely unattractive valuation?”

Adviser: “I have learned the hard way that market timing is very difficult and is generally a terrible idea. It’s better to just own this asset class all the time regardless of its prospective return.”

Investor: “Okay. So you’re saying you’re not confident in your ‘prospective return?'”

Adviser: “No. We’re confident. We have a variety of valuation measures that are highly correlated to the future 10-year returns of this asset class and they all say the same thing: that it’s very highly likely to return zero or less over that time frame.”

Investor: “So you’re saying that you have proven valuation measures that have been highly accurate in forecasting the return of this asset class for decades but you don’t think they’re very useful.”

Adviser: “That’s right.”

Investor: “Gotcha. I’ve got an even better deal for you. How about I sell YOU an investment that returns nothing over the next 10 years? That’s better than negative right? I’ll take the money and put it into risk-free treasuries, keep the difference between what they pay me and what I pay you (nothing) and then pay you your initial investment back at the end. How much would you like to buy?”

Adviser: “Only my employer (major bank) and the Fed can play that game, I’m afraid.”

*Thanks to Henry Blodgett for playing the “adviser.”

**US Equities


It Pays To “Think Different” About Apple’s Stock Price

About 10 months ago I wrote that I thought Apple was worth $114 to $128 per share (split adjusted). That day the stock closed at $72. Today it closed at $116, 60% higher. So this morning I sold it. Here’s why:

Fundamentally, the company has gone from being very undervalued to fairly valued in a very short period of time. (Note: Carl Icahn, who is a lot smarter than I am, says the company is worth $200 per share. I just don’t know how much of this is salesmanship/optimism and how much is cautious analysis.)

I know, I know, Apple is firing on all cylinders and will probably continue to do so. iPhone 6 is selling like hotcakes even before we get into the holiday shopping season. New products are in the pipeline and Apple Pay will probably be huge for the company.

But how much of this optimism is already baked in to the current valuation? At 5 or 6x cash flow, almost none of this was priced in. At nearly twice that valuation today I’m not so sure. Ultimately, at the current price I no longer have a margin of safety. Should the company stumble, and I’m not saying they will, there’s no reason the stock couldn’t go back to the $80-95 level (where I’d probably buy it back).

Screen Shot 2014-11-21 at 12.18.53 PMAnd this is where fundamentals and sentiment get blurred. Clearly, investors don’t quite love the stock as much as they did during the summer of 2012 (will any stock be that loved ever again?) but they no longer think Samsung is going to eat the company’s lunch. So I wouldn’t say sentiment is super-frothy but a 60% run in 10 months tend to inspire at least a little euphoria and StockTwits sentiment has reflected that for some time. 90% of the messages on the site tagged with Apple’s ticker are bullish. That’s a pretty crowded trade.

As for the long-term trend, clearly it’s still bullish. But there are some signs that it may be getting exhausted. DeMark Sequential sell signals are now triggering on multiple time frames. A daily 13 sell signal registered at today’s open while another 9 sell setup triggered a couple of days ago. All this means is we are seeing a cluster of trend exhaustion signals currently:



The weekly sell signal won’t trigger until the Monday after Thanksgiving but this time frame gives us a good look at the action over the past couple of years. The stock famously peaked in the summer of 2012 before losing roughly half its value into the spring of 2013. The stock has since rallied back and broken out above that prior high (taking the major indexes with it). A simple 1.618 Fibonacci extension projects a target of roughly $122.



Interestingly, that 2012 peak was accompanied by a completed monthly DeMark 9 sell setup. Last month the stock triggered a monthly 13 sell signal off of that same setup. The risk level for this monthly signal sits at roughly $121. Coincidentally, that’s also the risk level for the daily signal. So according to DeMark Sequential analysis on multiple time frames, the stock could continue to run to $121-122 to test these risk levels and complete the 1.618 Fibonacci extension on the weekly chart.



From where I sit, however, the stock has pretty much reached fair value, sentiment has shifted positively once more with investors nurturing great expectations for the holiday season and the parabolic move over the past few weeks has triggered a flurry of sell signals. So I’m not saying this is the top. I’m just saying I’ve had my fun and the risk/reward equation no longer appeals to me.


Dogma and Denial

“Don’t Be Trapped by Dogma – Which is Living With the Results of Other People’s Thinking” -Steve Jobs

There is a very strong and popular dogma out there that says, ‘you must own US stocks all the time no matter what.’ It’s really at the heart of the “buy and hold” mantra which is something I’ve railed against recently.

I’ve railed against it because it’s pretty plain to see that there are times when US stocks are attractive to own – the vast majority of the time, in fact. But there are also times when they really aren’t.

Right now just happens to be one of the very few times US stocks have offered investors a negative 10-year forecast return based on Warren Buffett’s favorite valuation metric (total market capitalization to GNP).

So I ask, “why in hell would you want to hold something that is likely to give you a negative return over the coming decade?”

I imagine these dogmatists would answer, “because you can’t time the market.”

To which I would answer, “On what time frame? Because it’s pretty clear that this tool is fairly good at predicting 10-year returns. (It’s about 83% negatively correlated).”

Admittedly, on a one or two year time frame it has little or no value in timing but is that your investment horizon? If so, you shouldn’t hold ANY stocks at all, US or foreign! On the other hand, if your time frame is 10 years or longer you should probably be very interested in what a measure like this has to say. And it’s not just this one. There are measures that are even more closely correlated to future 10-year returns that say essentially the same thing: stocks are extremely highly-valued/offer unusually low rates of return.

And there are plenty of other asset classes to own that offer more attractive prospective returns! Hell, the 10-year treasury bond, at a mere 2.2% yield may offer better returns than US stocks over the coming decade with FAR less risk (so long as you intend to hold to maturity). In fact, nearly ANY other country around the world offers better value/prospective returns than US stocks do right now.

So why the hang up? Why are investors (and their advisers) so stuck on dedicating the majority of their investable assets to US stocks despite the fact that they are so unattractively priced?

My best guess is they are simply in denial. They are so enamored with the returns they’ve witnessed over the past five years that they simply refuse to even entertain the possibility that stocks may serve up anything less going forward. And that’s just a shame because it’s precisely at times like these investors should question this sort of dogma, rather than near the end of a bear market when they usually finally do decide to abandon it.


Over A Barrel

A local craft brewer announced recently that they’re being bought out by Anheuser Busch and at first I thought, ‘Cool. Good for those guys.’ But then there was a fairly large customer backlash that got me thinking a bit more about it. Why does everyone get pissed when a company like this “sells out”?

The 10 Barrel guys say they sold because AB gives them opportunities they wouldn’t otherwise have. They obviously get better distribution but they also get access to used brewing equipment and ingredients that are hard to come by in today’s booming craft beer market.

That’s all fine and good but every company goes through these sort of growing pains. Surely Deschutes Brewery and Sam Adams went through these very same problems as they grew from small town craft brewers into two of the largest in the country. They managed to overcome these very same hurdles without selling out.

Ultimately, it’s easier to solve these problems by selling to a buyer like AB or even just to any buyer and then letting them figure it all out. But is it the right thing to do for your brand, for your customers, for the long-term health and vibrancy of your business?

I think the main reason people get pissed is because when a company sells out it sends a clear “show me the money” message. It tells people that profits are your top priority. And in the capitalism capitol of the world you’d think, ‘well, what’s wrong with that?’

What’s wrong is people want their companies to stand for something more than just profits. Look at the companies that have the greatest brand loyalty. Why do people love them so much? Apple, Twitter, Amazon. And smaller companies, like Ben & Jerry’s, In-N-Out Burger, Patagonia. What makes their customers so loyal?

It comes down to the company’s mission. Truly – don’t laugh. I know Twitter got some flack for the their mission statement last week but it’s precisely because the company puts their users first that they remain loyal. It’s simple, really. A company has to stand for something more than just profits for it to engender any sort of loyalty.

Apple has consistently told Wall Street that their top priority is creating amazing products. Period. Profits are an afterthought. Amazon clearly prioritizes their customers over profits. I don’t think they’ve made a dime of profit over the past decade. Ben & Jerry’s and Patagonia are both about doing social good while you sell top quality products. In-N-Out sells fresh, quality burgers at low prices.

Nowhere will you find any of these companies talking about how maximizing profits is their reason for being. Sure, they think about it but it’s not the reason they do what they do. They have a passion that goes totally above and beyond.

And I purposely left out Facebook in the list companies above because I believe they have a sellout problem similar to 10 Barrel. They sold out to Wall Street when they went public. They started prioritizing profits above their users and that’s why a little site like ello, with an inspiring “manifesto,” can come in and begin to steal Facebook’s users (whether they do on a grander scale is yet to be seen). I don’t have the data but I’d be willing to bet almost any amount that ello users are significantly happier with and more loyal to the site than Facebook’s. Because Facebook is a sellout.

So when you sell out, you’re effectively telling your customers that nothing really matters as much to you as making a buck and that’s just a bummer. It’s also why people hate Wall Street. Because Wall Street’s whole reason for being is to make a buck. There is no higher purpose.

Disclosure: I own Apple for myself and for clients. I’m short Facebook for myself and for clients.

UPDATE: My friend Lee notified me that Ben & Jerry’s sold to Unilever back in 2000. Looks like they setup the deal in a way that allowed them to maintain their mission (see: “Ben & Jerry’s to Unilever with Attitude“). Who knows? Maybe 10 Barrel will find a way to do the same.


How To Handle An Environment Of “Low Returns”

First off, if you are expecting to achieve historical average rates of return from stocks or bonds from current prices please go read, “How To Time The Market Like Warren Buffett.” The bottom line is a 10-year treasury note pays you little more than 2% per year and stocks are likely to earn you even less over the next decade. So what’s a prudent investor to do? Here’s Howard Marks on your options:

How might one cope in a market that seems to be offering low returns?

  • Invest as if it’s not true. The trouble with this is that “wishing won’t make it so.” Simply put, it doesn’t make sense to expect traditional returns when elevated asset prices suggest they’re not available. I was pleased to get a letter from Peter Bernstein in response to my memo, in which he said something wonderful: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
  • Invest anyway — trying for acceptable relative returns under the circumstances, even if they’re not attractive in the absolute.
  • Invest anyway — ignoring short-run risk and focusing on the long run. This isn’t irrational, especially if you accept the notion that market timing and tactical asset allocation are difficult. But before taking this path, I’d suggest that you get a commitment from your investment committee or other constituents that they’ll ignore short-term losses.
  • Hold cash — but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t.
  • Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy.

The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action — one classic mistake — that I most strongly feel is wrong: reaching for return.

-Howard Marks, “There They Go Again,” May 6, 2005

Clearly, investors are currently “reaching for return” like never before. I have no doubt this episode will any any differently than it has in the past. For prudent investors, however, I think the best options are currently either 3 or 4, so long as they understand all the pros and cons of each.

Choosing the third option means you should be willing to tolerate another decline of up to 50% over the next decade in an attempt to capture the low single-digit returns stocks currently offer. That’s just the simple risk/reward equation current valuations present investors with.

Choosing the fourth option means you may have to hear your friends brag about their gains for a while should the market witness another bubblicious blow off akin to the 1998-1999 episode.

Which is the lesser of the two evils for you? Neither are very appealing but that’s the name of the game when you’re playing financial market limbo.

For more Howard Marks I highly recommend you read his excellent book, “The Most Important Thing


The Trend Is Now Your Frenemy, Part Deux

A month ago the major indexes broke down below their uptrend lines. They have since gained back all of their losses and then some. But that doesn’t mean everything’s peachy again.

In fact, I believe there’s a good chance that last month’s correction was only the beginning of a resurgence in volatility and very possibly could evolve into a major topping process for the stock market.

I’ve spent a lot of digital ink here discussing how overvalued I believe the market is currently. Mr. Buffett’s favorite yardstick, total market cap to GNP, shows the market to be currently trading at a level that is nearly twice its long-term average valuation. In other words, stocks would need to fall nearly 50% just to return to an average level, let alone an undervalued one.


Sentiment is also stretched about as far as it has ever been. Investors could hardly be more bullish than they are today, based simply on the percent of household financial assets allocated to stocks. In the simplest terms, this means that potential demand for stocks is not nearly as great as potential supply (see Philosophical Economics’s terrific post on the supply demand dynamic in stocks).


While these two measures are very highly correlated to future 10-years returns in the stock market, they have very little utility in trying to time a market peak or even a correction. That’s why we have to consider the overall trend. Fundamentals and sentiment won’t tell us when the trend may be coming to an end. Only the market can tell us that.

And the market is sending plenty of signals that this may be happing right now.

The simplest way to analyze a trend is to see if prices trade above or below a simple 200-day moving average (approximate to the 10-month moving average) and/or draw a long-term trend line. (Meb Faber recently wrote an interesting piece on just how important the 200-dma is to hedge fund titan Paul Tudor Jones). And this is what we looked at in the last post in this series.

But we can also get a good feel for the overall health of a trend by looking at what is commonly called its “internals.” This is just a fancy way of referring to things like the percent of stocks trading above their respective 200-day moving averages, the cumulative advance/decline line and the number of new 52-week highs or lows being made.

Essentially, these are all ways to look at how the components of an index are performing relative to the overall index. A healthy trend is driven by a majority of the index’s components. Likewise, an unhealthy or weakening one is driven by fewer and fewer components. (Lowry’s has done some fantastic research on this phenomenon you can read here).

Right now all of these measures are suggesting that the current long-term uptrend is waning in strength. Let’s take a look first at the NYSE Composite:


This index is actually one of the few that has failed to make new highs during the ramp over the past few weeks. Still, it’s plain to see that the cumulative advance-decline line (top black line), the percent of stocks trading above their 200-dmas (middle black line) and the pattern of new highs-new lows (bottom black bars) are all diverging from the new highs being made by the major indexes. The last time all three of these internal indicators diverged this way was in October of 2007, just prior to the bear market that coincided with the financial crisis.

The Nasdaq Composite looks very similar:


The main difference here is that the three indicators diverged not just in 2007 but also in 2011 prior to the selloff precipitated by the European sovereign debt crisis. Overall, I think it’s safe to say the current uptrend is not as healthy as the bulls would like to see. And both of these composite indexes are important components of the S&P 500 index so don’t think it’s immune.

Still, it’s true that prices for both of these indexes have regained their 200-day moving averages and multi-year uptrend lines. Ultimately, this tells me that the overall uptrend is still in tact. But these internal diverging indicators suggest that it may be nearing its end as more and more of the underlying components have, in fact, given up their own uptrends.

What’s more, considering the extreme levels of overvaluation and bullish sentiment, the next cycle lower, when it does finally turn, may be more than just your average market correction.