By Steve Blumenthal
“Nearly all men can stand adversity, but if you want to test a man’s character, give him power.”
– Abraham Lincoln
Do you remember back in the early 80s when interest rates peaked at 15.25% and most everyone felt rates were moving higher, certainly not lower? The fact is, it was the single best time in history to get bullish on bonds.
Solomon Brothers’ head of research Henry Kaufman went from bond bear to bond bull and that call, unpopular as it was, later earned him “guru” status. The thing is, at that time, most people thought he was nuts.
Recall too that inflation was in the mid-teens and both stocks and bonds had burned investors over the prior decade. Fed Chairman Paul Volker stood tall in his fight to rein in inflation. Kaufman’s bullish call went on deaf ears. Few seized the opportunity.
I remember my mentor, John Ray (then a portfolio manager at Delaware Funds) telling me a story about an investment committee meeting where he stood before his colleagues and said we should put 100% of our money in long-term Treasury bonds and call it a day (or maybe call it 32 years as that investment beat stocks by a large margin). John’s bullish call went on deaf ears.
Let’s pause and look at the current situation from 35,000 feet. Back then we were trying to defeat inflation by driving ultra-high interest rates even higher. Today, we are trying to create inflation by driving ultra-low interest rates even lower. Who wanted to buy bonds in the early 80s? The past 1, 3, 5 and 10 years of performance were abysmal. It was the right thing to do. Everyone wants to buy bonds today. Just look at the fund flows.
Investors look at recent performance and project it forward. This has to stop!
It’s a fine mess we find ourselves in. So here is the skinny. The bond market has little juice left to provide your portfolio with the help it provided you in the past. The same is true for the equity market as you can see next in GMO’s 7-Year Real Asset Return Forecast:
For the S&P 500 Total Return Index, that’s -2.3% per year for seven years. And, as you see, there is a lot of below 0% numbers across categories in the chart. Show this to everyone you know (especially your clients).
By the way, over the last decade, GMO’s forecasts had a 93.6% correlation to what they predicted and what actually happened. In non-geek terms, that’s pretty spot-on. No guarantees, of course, but we should take note.
All of this perhaps more eloquently expressed by Bill Gross in his latest missive entitled, “Bon Appetit!”
With interest rates near zero and now negative in many developed economies, near double-digit annual returns for stocks and 7%+ for bonds approach a 5 or 6 Sigma event, as nerdish market technocrats might describe it. You have a better chance of observing another era like the previous 40-year one on the planet Mars than you do here on good old Earth.
We are in the late stages of an economic game of musical chairs. Not many open chairs remain. We circle around and when the music stops, we race quickly to find an open chair. At the end of the game, there are few winners yet we all think we can play it and act quickly when the music stops. The Fed is in control of the music.
Many will lose but the game will be reset (higher interest rates and lower stock prices) and on we will go and play again. Let’s not lose the game. For now, be smart, play defense, be patient and know that there are many ways to make money. I share a few ideas in the conclusion below.
Today, let’s quickly take about the Fed (a behind the curtain view) and their probable course of action and then, in bullet point form, share with you my notes from Mark Yusko’s outstanding presentation at the recent Strategic Investment Conference (hosted by my good friend simply now known as Mauldin). By the way, I’ve ordered the audio recordings and will see if I can get permission to share a link to Yusko’s presentation with you. It was outstanding and, overall, I believe it is well captured in this next quote from Bill Gross.
The “fact of the matter” – to use a politician’s phrase – is that “carry” in any form appears to be very low relative to risk. The same thing goes with stocks and real estate or any asset that has a P/E, cap rate, or is tied to present value by the discounting of future cash flows. To occupy the investment market’s future “penthouse,” today’s portfolio managers – as well as their clients, must begin to look in another direction. Returns will be low, risk will be high and at some point the “Intelligent Investor” must decide that we are in a new era with conditions that demand a different approach. (Emphasis mine.)
With that, let’s get started. Grab a coffee or maybe two – I share a number of “what do we do” ideas.
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Included in this week’s On My Radar:
- Fed Up
- Mark Yusko’s Presentation – There Goes The Boom
- Trade Signals – Global Recession Probability High, No U.S. Recession Yet
I had dinner with Danielle DeMartino Booth last week in Dallas. Danielle is a former senior analyst for Richard Fisher and worked with him during his time as the Dallas Fed president.
Danielle co-hosted a private dinner and I was fortunate to be seated next to her. I have been reading Danielle’s weekly blog since I saw her last June on CNBC (via ZeroHedge.com). The piece was titled, “Another Fed ‘Insider’ Quits, Tells The Truth.” Read her blog, she’s really smart.
In a few short months, Danielle is coming out with a book titled, Fed Up. Our dinner discussion was honest, direct and candid. A bit of a peek behind the great curtain.
Honestly, I can’t tell you I feel any better and, in fact, I feel worse. Much of what I believe was confirmed.
Smart people were at the conference, like former Dallas Fed president Richard Fisher, and have tried to stress the business behavioral reactions to policy but, to be clear, there is not much hope in a change of monetary religion. Their hope to unleash animal spirits is not the outcome they are getting. They are guessing with blind faith in a flawed model.
Janet Yellen and her team of 750 plus PhDs are being tested. “… But if you want to test a man’s character, give him power,” said Lincoln. Of course, man is defined to be woman or man. Her character and her leadership, like Volker’s in the early 80’s, is at test.
The bottom line, in my view, is that the Fed lacks real world business experience. Banks are sitting on $2 trillion of the Fed created