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"The Grand Disconnect" and A. Gary Shilling's bond advice


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Many times, A. Gary Shilling has spoken of a "Grand Disconnect" in the stock market price. 

 

But he has also made some comments on bonds -- last year for example he put this in the Globe & Mail:

 

http://www.theglobeandmail.com/globe-investor/inside-the-market/qa-gary-shilling-on-why-the-latest-rush-into-stocks-will-end-miserably/article7596047/

 

I'm adding some highlights in bold:

 

Prices have just skyrocketed, since the yield has now dropped to 3 per cent. I’ve never, never, never bought Treasury bonds for yield. I couldn’t care less what the yield is, as long as they are going down. In other words, I want the appreciation and that’s the same reason most people buy stocks of course. I’m of the opinion that if we’re right, and there’s a global recession shaping up, that will reduce demand for credit, and it will enhance the appeal of treasuries as a safe haven, and it will probably get more people worried about deflation then inflation. Those three factors I think could drive yields on treasuries down further, and if they go down further, we will go from 3 per cent to two per cent. You’ll have appreciation of about 16 per cent on a 30-year coupon bond assuming it takes place over a one year and you get a year’s worth of interest. And on a zero coupon bond it’ll be a total return of about 25 per cent.

 

Alright, now balance that against his view that the deleveraging will only go on for 5 more years, after which we'll be back to 3.2% real long term trend GDP growth (he says that here: http://www.bloomberg.com/news/2013-08-26/the-strong-case-for-optimism-about-u-s-growth.html)

 

 

Additionally, he is perfectly aware that QE3 has been pushing down the long yields and openly talks about how they'll need to stop doing that before the 5 years is up (well, of course he says that, after all who wouldn't).

 

So what I'm working around to asking, is that is perhaps the bigger "Grand Disconnect" in fact that Shilling thought there was value in the 30 year bond last year at 3% rates, on the speculation that they would drop to 2%?  Why would they be worth a 2% yield when GDP growth will resume at 3.2% after just 5 years of the 30 year life of the bond?  Plus, the starting yield was being held down by Fed intervention, so where would it have been without QE3?  Was there a Grand Disconnect to ignore the threat of tapering?

 

He talked about a 100bps movement in the zero coupon bond to return 25%.  How much did he put into that bet?  He must be getting quite an ass kicking this year to date on that.  Wouldn't it be the reverse of 25% if rates go up by 100bps?  The 30 year is now at 3.9% today.

 

Why is he so ready to advise getting out of stocks (on a forecast of recession) and tempting people with 25% gains on bonds, when he feels growth is going back to 3.2% real rather early in the life of those bonds?  This seems incomprehensible.  I agree that it was a perfectly logical call to get out of stocks last year if there was threat of recession, but betting on the market to serve up 25% gains in zero coupon bonds (he was implying it to be an opportunity) with the risk of tapering and the market figuring out (like he has done) that "Age of Deleveraging" would conclude in 2019... how much can you expect the market to price in deflation that would serve to be so short-lived?  And wasn't it priced in already at 3% yields?

 

I don't hate the guy -- I just find his thoughts on bond investing to be equally a "Grand Disconnect" as he attributes to the stock market investing.  Yet he chooses a favorite.  In both cases, arguments can be made that the fundamentals he is expecting (recession and recovery from delivering) don't fit the market prices of either stocks or bonds.  Based on that, I would figure he would be espousing short-duration bond strategy for preservation of capital.  Which is a fine strategy if you are uncertain.  But he just wants to chase capital appreciation on truly a greater fools game of betting the market won't figure out that deleveraging is coming to an end, as well as tapering eventually coming. 

 

Is it generally perceived that chasing treasury bonds for capital gains is somewhat safer than chasing stock market for capital gains, even when just chasing them for short-term fundamental reasons?  By short term fundamental reasons, I mean to say that one can argue that stock market earnings are only going to be high for the short term, and equally one can argue that bond yields are going to be this low only for the short term.  In both cases, if you believe in that being truly short term, then you are just making a risky game.

 

One could argue that five years is pretty long term, but not in the context of 30 year instruments -- it's only 1/6 the time of the full duration, which is relative small (short term).

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I think his assumption of long term real GDP growth reverting to 3.2% is just a reversion to the mean statement.  To answer your question here

 

So what I'm working around to asking, is that is perhaps the bigger "Grand Disconnect" in fact that Shilling thought there was value in the 30 year bond last year at 3% rates, on the speculation that they would drop to 2%?  Why would they be worth a 2% yield when GDP growth will resume at 3.2% after just 5 years of the 30 year life of the bond?  Plus, the starting yield was being held down by Fed intervention, so where would it have been without QE3?  Was there a Grand Disconnect to ignore the threat of tapering?

 

I would turn to the case laid out by Lacy Hunt http://www.hoisingtonmgt.com/pdf/HIM2013Q2NP.pdf who as you might recall was referenced in Prem's most recent annual letter and I think has largely helped shape his deflationary views. 

 

The effect of each of the quantitative easings was the opposite of the Fed’s intentions. During every period of balance sheet expansion long rates rose, yet when securities purchases were discontinued yields fell (Chart 6). The Fed cannot control long rates because long rates are affected by inflation expectations, not by supply and demand in the market place. This is extremely counter intuitive. With more buying, one would assume that prices would rise and thus yields would fall, but the opposite occurred. Why? When the Fed buys, it appears that the existing owners of Treasuries (now amounting to $9.5 trillion) decide that the Fed’s actions are inflationary and sell their holdings, raising interest rates. When the Fed stops this program, inflation expectations fall creating a demand for Treasuries, bringing rates back down. The Fed’s quantitative policies have been counter productive to growth as interest rates have risen during each period of quantitative easing. During QE1 and QE2, commodity prices rose, the dollar fell and inflation rose temporarily. Wages, however, did not respond. Thus, the higher interest rates during all QEs and the fall in the real wage income during QE 1 & 2 served to worsen the income and wealth divide. This means many more households were hurt, rather than helped, by the Fed’s efforts.

 

I can't figure out how I'd paste the charts in without cropping and uploaded them myself but I'd reference charts 1 and 6 that support his case.  What he lays out is pretty convincing and they have an excellent track record in managing treasury bonds.  I'm in the process of reading all his commentaries (I have them going back to 2000) to see his process over a cycle.  Still I find it hard to imagine myself going long 30 year zero coupon bonds at the moment as it reminds me too much of how I think of merger arbitrage.  Like picking up pennies in front of a steamroller.  Certainly a contrarian view to keep in mind though. I found it striking that in the most recent Barron's financial adviser survey the largest consensus on anything they asked about was that 91% had a negative view on US Treasuries http://online.barrons.com/article/SB50001424053111904462504579135833535241144.html?mod=BOL_archive_twm_ls#articleTabs_article%3D0  Actually tied with Sears also 91% negative.  I like reading a decent case that is against the consensus.

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I think his assumption of long term real GDP growth reverting to 3.2% is just a reversion to the mean statement. 

 

Where does that take us in terms of translating mean reversion to a "fair" price for the long 30 yr bond?

 

How much should the 30 year bond be discounted for the uncertainty of the next 5 years?

 

The interesting thing is that Shilling's 2% target on that 30 year bond implies giving up 190 bps per year (from today's rate) for the last 25 years life of the bond.

 

The reason that makes no sense to me is that you don't need the safety of long treasuries to protect yourself from a 5 year period of time.  5 years is way too short.  Expecting it to trade at 2% yield in order to ride out a tough 5 year period is an extremely irrational expectation of Mr. Market, in my opinion anyhow.

 

What risk of deflation is coming over the next 5 years that you can't safely hide from in short-duration treasuries? 

 

I don't know if he was seduced by looking at the potential gains and then trying to justify it or what.  But if you use straight logic, nobody should accept 2% yields for the following 25 years if they expect the deleveraging to be over in just 5 more years. 

 

Thus I think there is some disconnect here between what he wanted Mr. Market to throw at him, and his prognosis for how much longer he expects this economy to complete the deleveraging and return to normal growth.

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I would turn to the case laid out by Lacy Hunt http://www.hoisingtonmgt.com/pdf/HIM2013Q2NP.pdf who as you might recall was referenced in Prem's most recent annual letter and I think has largely helped shape his deflationary views. 

 

The Hoisington letter talks about the trouble with the US consumer, and the recently poor GDP growth rates.  All of that of course is a symptom of the current deleveraging process.  Then the letter goes on to say at the end that the US is tracking towards 2% long term interest rate 13 to 14 years after the collapse (following what happened in Japan).

 

That's fine if that's their viewpoint -- it supports why Lacy Hunt and Van Hoisington want to be in bonds.  They see poor GDP growth and their comment about 13 or 14 years suggests they don't see this as a short term thing.

 

No, the confusion I have over Gary Shilling, why I think he is going through a disconnect of his own, is that he isn't seeing this as continuing for more than another 5 years.  Yet despite this 5 year view, he still thinks long rates will bottom.

 

The Hoisington letter points out that the single most important ingredient to long term rates is the inflation expectations.  But if you believe that GDP growth will be back at 3.2% real in just 5 years, then you cannot simultaneously have this inflation expectation that would drive yields down to the 2% level on a 30 year bond.  That level of rate at that duration isn't consistent with a business as usual GDP growth rate environment for a full 25 out of 30 years.

 

So that's what I'm saying is the disconnect.  It's that Gary Shilling's expectation for the interest rates is disconnected with his expectation that the GDP growth will recover again in just 5 years.  That kind of recovery timeline would presumably bring inflation expectations with it that wouldn't allow for a 2% yield on 30 year bonds.

 

But I agree with you that Van Hoisington and Lacy Hunt are not in a similar disconnect -- they aren't openly stating that GDP growth will be back to normal in 5 years.  So their views on bond price direction isn't disconnected with what they believe.

 

I'm not saying that Shilling is going to be wrong about interest rates -- I have no idea.  I'm just commenting that his viewpoints on economic recover seem to be disconnected with his interest rate expectations.  He could be wrong about the recovery and right about interest rates.  He could be right about both and for a while interest rates could bottom at 2% if people get very pessimistic temporarily.  I just find it odd that he has this viewpoint that recovery will happen in 5 years but an investment stance that depends on the market not realizing it -- like he's smart enough to figure it out but estimates that the market won't be.

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Ah I see your point now.  And yes sorry with Lacy Hunt's point I was more referring to the question about yield being held down by the Fed.  I guess to make Shilling's argument you have to believe that inflationary expectations will remain low despite strong economic growth.  If you believe that that interest rates as a product of real interest rates and inflationary expectations.  I don't know enough about economic history to try and make that argument myself, macro economic history is a recent hobby, but I would be curious to look at the 1929-1953 periods where rates remained low but real GDP went from 1,055,640 on Jan 1929 to 2,568,912 in Jan 1953 which is ~3.75% per year if I did my math right.  And that's not starting at any bottom (1933) which would have shown stronger numbers.  Looking at a different set of interest rates it doesn't look like they crossed the Pre Great Depression rates until ~1966 when CPI change ticked up toward 5%.  I guess you could maybe pick 1949 to 1966 instead to exclude the war years where inflation spiked.  But, throughout this entire time period you had strong economic growth, low interest rates, and generally low inflation.  Certainly an uncommon time but I think it may be possible to make a case.  For kicks I looked at the YOY growth rates of CPI and took the geo mean for a few time periods.  I was surprised how low it was even with the war year spikes.  If your goal was preservation of capital or purchasing power you would have done ok. 

 

1929 - 1966 1.77%

1929 - 1953 1.80%

1939 - 1966 3.12%

1945 - 1966 2.98%

 

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Ah I see your point now.  And yes sorry with Lacy Hunt's point I was more referring to the question about yield being held down by the Fed.  I guess to make Shilling's argument you have to believe that inflationary expectations will remain low despite strong economic growth.  If you believe that that interest rates as a product of real interest rates and inflationary expectations.  I don't know enough about economic history to try and make that argument myself, macro economic history is a recent hobby, but I would be curious to look at the 1929-1953 periods where rates remained low but real GDP went from 1,055,640 on Jan 1929 to 2,568,912 in Jan 1953 which is ~3.75% per year if I did my math right.  And that's not starting at any bottom (1933) which would have shown stronger numbers.  Looking at a different set of interest rates it doesn't look like they crossed the Pre Great Depression rates until ~1966 when CPI change ticked up toward 5%.  I guess you could maybe pick 1949 to 1966 instead to exclude the war years where inflation spiked.  But, throughout this entire time period you had strong economic growth, low interest rates, and generally low inflation.  Certainly an uncommon time but I think it may be possible to make a case.  For kicks I looked at the YOY growth rates of CPI and took the geo mean for a few time periods.  I was surprised how low it was even with the war year spikes.  If your goal was preservation of capital or purchasing power you would have done ok. 

 

1929 - 1966 1.77%

1929 - 1953 1.80%

1939 - 1966 3.12%

1945 - 1966 2.98%

 

One thing to note -- the US went off the gold standard after those dates.  I believe the gold bugs do have some point about that event and inflation risk.  So when comparing historical interest rates, I like to think about risk premiums. 

 

Do you feel comfortable endorsing the following statement:

 

There should be absolutely no risk premium to compensate investors for fiat currency backed bonds versus gold backed bonds.  None whatsoever.  It is perfectly reasonable to compare bonds paying gold-backed coupons to fiat-backed coupons.  No added risk of debasement to the coupon thus no premium.

 

Surely, there is a reason why the TIPS trade at a lower yield to non-TIPS.  Wouldn't the same be true if the Fed introduced 30 year bonds tomorrow that paid a coupon fixed in ounces of gold, not fiat dollars?

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No I wouldn't endorse that statement, but I do enjoy playing devils advocate.  The US was on the Gold Standard, but that did not prevent them from debasing their currency.  From 1933 to 1934 the US devalued their currency by 60%.  You had numerous examples in WWI and Great Depression era of countries simply abandoning the gold standard.  If investors saw that you could change the rules shouldn't they have demanded a premium?  Yet rates drifted lower from '34 to when we entered the war. 

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No I wouldn't endorse that statement, but I do enjoy playing devils advocate.  The US was on the Gold Standard, but that did not prevent them from debasing their currency.  From 1933 to 1934 the US devalued their currency by 60%.  You had numerous examples in WWI and Great Depression era of countries simply abandoning the gold standard.  If investors saw that you could change the rules shouldn't they have demanded a premium?  Yet rates drifted lower from '34 to when we entered the war.

 

The gold standard was no guarantee -- going back to the period after 1915, there was like 50% inflation because the First World War experienced a flight of gold from Europe to America.  That encouraged inflation.

 

I don't know, I feel like having a gold standard makes a lot of investors feel better about their chances of getting a real return over a very long 30 year period -- or at least it sounds romantic enough that investors should pay a bit more for the flirtation.

 

 

But I was talking about Shilling -- he mentioned a 2% rate on the 30 year bond.  That totally blows away the rates of the periods you mentioned -- I don't think the 30 year bond was even introduced yet.  They had 10 year, and I think 20 year.

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So this page here has a 100 year history of the 10 year treasury bond:

 

http://observationsandnotes.blogspot.com/2010/11/100-years-of-bond-interest-rate-history.html

 

How often has it even gone close to 2%?  Hmm?

 

And Gary Shilling invests purely on the speculative price rise that he expects to earn as the yield drops to 2%.

 

He's talking about the THIRTY frigging year bond!!!!  Not the 10, but the 30!!

 

The 10 has barely ever gone near 2% in 100 years, and he wants to ride the 30 all the way to 2%.  It's sort of disconnected in a way, IMO.

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Yeah I don't think the 30 year was introduced until the '70s so that our government in a brilliant stroke could lock up its highest borrow cost in history long term. I'd have to do some reading but I believe the war bonds were 10 years and sold for as little as 2.75% during peak propaganda. 

 

But back to Shilling, its an interesting mental model because he's not talking about sustained 30 year rates that low.  He just thinks that there will be a deflationary event that sparks the drop to those rates before a sharp recovery.  In essence a greater fools theory that you can take the capital appreciation of the rate drop because someone would be foolish enough to pay that rate in a time of crisis.  But that crisis can't be Lacy Hunt's "Bang Event" which causes government interest rates to spike over fears of being able to be repaid.  I guess if I were to try and put myself in that fools shoes I would cite the Market Segmentation theory, i.e. that the yield curve reflects supply / demand.  There are always going to be forced buyers at any price.  Insurance companies trying to match liabilities, pension funds with mandates, etc.  That's kinda an out answer though.  If your down to just those forced buyers does that keep you at 2%?  I doubt it.  Though if short term rates which the Fed largely can control drop below inflation I could certainly see people reaching just above the water for that 30 year and a real positive interest rate not contemplating that if interest rates rise they'll just sink below faster.  Still to buy a 30 year at a 2% rate w/o the mandate you have to A) believe there will be severe deflation for several years.  I could certainly cite the numbers to make that case but then it makes it difficult to explain the quick turnaround.  Enforced austerity maybe that forces an increase in the savings rate.  That's what happened during WWII.  Its not totally inconceivable that Uncle Sam enforces forced saving.  Or what if they government put further restrictions on what you can invest your IRA in.  To be tax free you have to put X% in government / muni bonds to "prevent excessive stock market speculation."  Or to take the opposite political angle a curtail on entitlements that spurs further saving / productivity.  These are extreme examples and would cause an uproar here (well maybe not the entitlements but that would cause louder uproar elsewhere) but is it totally inconceivable? Or B) things will be so bad that the perception changes from return on capital to return of capital.  Hard to make that argument in terms of taking a 30 year instead of something with a shorter maturity though.  However, I think there's merit to the idea that as short term rates cross the zero real return barrier people shift further out on the yield curve to seek out greater return even at substantially more risk.

 

Also 2% is just a number.  There's certainly a psychological lower bound of 0% but in real terms it doesn't mean anything if prices are dropping.  We've already seen rumors of banks threatening to charge depositors if the 0.25% discount window is removed.  If I'm Schilling, I could just point out that we've never had a deleveraging this large, i.e. more debt that ever, etc. so its not inconceivable that the rates will be lower than ever before, but you could correctly point out then how does he expect the 5 year turnaround. 

 

 

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His comments around the 5 year return to normal-trend real GDP growth were made in September 2013.

 

His comments about 2% 30-yr bond were made at end of 2012.

 

Did he simply lose a good deal of pessimism over those 9 months?  I haven't found any recent comment on his interest rate views.

 

Supposing he did invest a lot in the 30 yr, and suppose he did get a whooping this year -- it would have forced him to perhaps revisit his thesis and maybe shook him out of an entrenched tunnel vision.  He had been in that Deflation viewpoint for 10 years, since 2003.  He even wrote a book on it Age of Deleveraging by A. Gary Shilling.  So he had a lot invested in that thesis.  Getting so involved with a point of view, with so many interviews and media appearances, plugs for his book, etc...  it might be hard to extricate yourself and take a fresh impartial view.

 

Anyhow, I look for patterns and when A. Gary Shilling opened his mouth in September about a 5 year recovery runway, I took notice because it did not fit his investment thesis in 30 year 2% rate.

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