This article was originally published on January 25, 2010 by Samex Capital Advisors and is reprinted with their permission.
Bull markets come and go. Or do they? Investors buying US government bonds have experienced a nearly 30 year run of consistently higher prices with very little downside disruption. People often cite the powerful bull market in equities from 1980 to 2000 as a unique and amazing run. The current bond market, however, has now outlasted that “once in a lifetime” event by 10 years. We are witnessing an outlier, which by its very existence is begging to be explored. Over the last 20 years, the talking heads have had their say. It is now time for Samex to weigh in using the facts as market participants believe them to be. After all, its market action, not words, that count.
One easy explanation for the longevity of the bull market in bonds is the extreme stretch that occurred throughout the 70’s until 1981. US bonds were paying 15% by 1981, which is near historically high levels for any type of stable government in history. From one extreme to the next, which brought us to a coupon of 2.5% by the end of 2008 (Figure 1). Bond prices moved from $45 to a high of almost $140, and those returns don’t include annual interest payments. In essence, coming off the raging inflation of the 1970’s the interest rate environment was ripe for a long term decline. At some point, though, all good things come to an end. There is a real possibility that the highs for the bond market have been put in, and we are in the very early stages of what may turn into a powerful, sustainable and long term bear market for US government bonds.
A noticeable top in prices (low in yield), must be in place before a bear market begins. Increasing levels of selling pressure show up after investors realize that new highs are not coming for quite some time. The most recent high in the bond market was seen 13 months ago in December 2008, with the 30 year seeing a high tick of $142.66 and a Yield of 2.51%. 13 months is not enough time to declare an end to the bull market as there were 2 occurrences in the 90’s where it took about 3 years before a new high was seen. Another indication of coming investor pessimism is often lower prices.
Bond prices are down about 15% from the December 2008 high. In and of itself that may not be enough to kick up the fear factor to the point of seeing sharply lower prices in the near term. It is important to keep in mind, though, that bear markets typically see the worst selling near the later stages of the cycle. Early price drops usually lead people to convince themselves that they are seeing normal market action.
Why is it then, we believe the great bull market in bonds is over? For this we turn to some traditional technical indicators such as trendlines and moving averages to provide a clear analysis of what is really happening. Using the 200 day moving average of prices has served well over the years to help determine bull or bear market status. The 30 year bond price fell below the 200 day moving average (Figure 2, red parabolic curve) in April 2009, and despite two attempts to recover in May and October, and a failure to hold above it, in late November, prices are firmly below what is now a clearly down trending 200 day moving average line.
A look at a chart of the yield for the 10 year bond is showing similar, although inverse characteristics (Figure 3). The yield is above the 200 day average and has been in a short term uptrend since late November. The rate is currently hitting some overhead resistance near the 4% level, which is an area that should be closely watched in the weeks ahead. A near term break above 4% will serve as a confirming indicator that we are indeed seeing a bear market.
Long running bull markets have a tendency to end in an explosion of activity. Think tech stocks in the late 90’s. The Nasdaq experienced a steady upward march throughout the 90’s until the middle of 1999 when the market went almost vertical as it doubled in less than a year. The commodity run in the 1970’s showed a similar trait with gold doubling in the last 18 months until it hit a 27 year high of $850 an ounce. On a chart, these moves look like mountain peaks and they stand out from the rest of the picture. Technical analysts call these terminal moves blow off tops. The near 30 year bond price peak in December 2008 was the sharpest run during the entire bull move going back to 1981 (Figure 4). It fits the bill of a blow off top.
There are a few reasons why bear markets inflict so much pain. One is the absolute sense of complacency investors are lulled into. They come to believe that risk is almost non-existent. By the late 1990’s, Wall St. had the public so convinced that the stock market always comes back that people were in total shock by the losses they soon incurred. The bond market has cast a similar spell over investors today. People view government bonds as close to a guarantee as possible. There is justifiable faith put into the credit worthiness of the US government, but that only applies to your return of capital, not return on capital. Including collected interest, investors lost about seven percent while holding the US government 10 year bond in 2009. And if yields break and hold above four percent over the intermediate term, 2010 could be worse. And take my word for it, these losses are completely unexpected.
Another reason bear markets hurt so much revolves around money management actions, or when and how much money investors put into an investment. As an asset really begins to move higher and grab public attention, investors pour more and more money into the investment. By that I mean the largest percentage of actual cash invested was put to work near the top. A better strategy is to buy smaller dollar amounts on the way up. If a person began buying $1,000 a month of tech stocks in 1995, they were buying $10,000 a month in 1999. That is why the 75% crash really ripped some investors’ hearts out. A similar path was followed recently in the government bond market. The Chinese are the biggest early victims, but the next two years will show pain surfacing in ways we simply cannot imagine today.
This leads us to the chain of events or domino effect that should eventually take place, most likely within the next two years. First, yields on longer dated US government debt will break out and begin another sustained move higher. Then inflation, which is currently a no show, will start to show up in obvious form. The next domino will be corporate bonds. Both investment grade and junk corporate bonds, are already showing signs of topping (Figures 5 and 6). Combine rising corporate borrowing rates, increased material input cost, with employees asking for higher pay to combat the inflation picture, and the stock market will get hit as it prices in lower corporate profits. As the market begins to fall, investors will come back to the bond market looking for a sense of safety again. This stage will keep rates from a repeat of the late 1970’s, but there is still a lot of room for the 10 year yield to see eight percent before a lasting retreat.
This entire scenario owes its potential existence to my favorite universal rule, the law of supply and demand. In order to solve the 2008 financial crisis, governments around the world issued record levels of debt, increasing the supply of bonds by an historical amount. The U.S. Treasury issued $1.7 Trillion of net new debt in FY 20091, projected $1.7 Trillion net new debt for FY 20102, and yet another $1 Trillion for FY 20112. In other words, FY 2009’s new debt almost equaled the total of debt added from FY 2000 through FY 2008. This incredible increase in supply is creating the inevitable drop in demand. As supply rises and demand falls, prices will eventually fall until a new equilibrium in the supply/demand curve is found. Until that new equilibrium is reached, investors would be well served to view bonds with a great deal of caution.
- Monthly Treasury Statement, FY 2009, September 30, 2009, Table 2, page 3
- Monthly Treasury Statement, FY 2010, December 31, 2009, Table 2, page 3
Scott Noble, an Investment Advisor Representative with Samex Capital Advisors, LLC, contributed to this article. Scott can be reached at, scott@samexcapital.com.
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