Lending money to the world’s biggest debtor has scarcely ever been more popular or less rewarding. This week, the yield on 10-year Treasury notes fell below 3.8%. Meanwhile, officially, consumer prices are rising at 5.6% per year. Producer prices in the United States were last clocked going up at almost 10%.
Bond investors are supposed to be the smartest of the lot. But there are times when the first become the last…when the smartest become the dumbest…and when yesterday’s roadmaps need to be turned upside down. This, we believe, is one of those times.
Between what bond investors stand to gain in yield and what they stand to lose from inflation is a built-in loss of 1.8%. Where’s the margin of safety? Where’s the upside? Why bother?
Bond investors are betting that the future stretches out before them just like the past. In that, they are broadly correct. But the trouble is, they don’t look at enough of the past. They need to turn their heads around. Looking in the mirror, they see only the straight road behind them…but not the hairpin curve a quarter mile back. It was just such a turn that flipped them over 26 years ago…and 36 years before that…and 26 years before that. The wrecks seem to come along about one per generation. Interest rates went down for more than a quarter century…then up from 1946 to 1982…then, down again.
Here, we are lured to a flagrant guess. We wouldn’t be the first to notice that it takes about as long for a major turn in the credit cycle as it takes for a man to forget the last one. And we won’t be the only ones to guess that, having forgotten the crack up of the ’80s, bond investors are ready for another one.
Major turns in the credit cycle mark Biblical urning points in investors’ fortunes. They are the points at which the smart money turns out be a half-wit. The meek stock and bond investors of ’82 inherited the world by 2000. Now it is their turn to be last.
By 2008, inflation rates have been going down…or holding steady at modest rates…for so long, the memory of man runneth not to the contrary. Or, at least, the memory of the current generation of investors runs not to the contrary. In their minds, life on Earth began on this month 26 years ago. In that hazy soup of a summer, you were considered foolish if you lent money on any terms to anyone. For a very simple reason: the money you got back would be worth less than the money you lent out. Even if you lent it to the best credit risk in the world – the U.S. government – you demanded a 14% yield to cover yourself. For those bond investors of the early Volcker years the road behind them had been bad enough; they were sure the road ahead led right to Hell. For them, inflation rates below 10% seemed as unlikely as gold below $300 or summer Olympics in Peking. Bonds were nothing more than “certificates of guaranteed confiscation,” and everybody knew it. The U.S. budg et deficit – then, about $200 billion – was all the proof you needed.
And so it was that the investors of ’82 threw out their stocks and bonds, stepped on the gas, and ran right into an oak tree.
A report from February 9, 1982, courtesy of the LA TIMES:
“The stock market plunged to an early-1982 low Monday in a selloff attributed to rising interest rates and gloom over the federal budget outlook.”
Investors in ‘82 had their roadmaps. They knew that Deficit Alley came out on a street marked “Inflation” and led directly to the Bear Market Highway. In the preceding 10 years, the dollar had lost nearly 2/3rds of its purchasing power; a bear market on Wall Street, combined with inflation, had taken 80% off the value of stocks; and there was hardly a bond investor still compes mentis who did not regret ever laying eyes on US Treasury paper.
By summer of that year, sweaty faces on Wall Street had become so long stockbrokers’ chins practically dragged on the hot pavement. In July, yields on the 10-year T-note reached 13.95% and in August, the Dow dropped to 776. Few investors wanted anything to do with either stocks or bonds; instead, they went to the beach with picnic baskets full of gold coins.
It was on the way home that the road took a sudden turn. Few realized it, but the bear market in stocks that began in 1966 ended that very summer. The bull market in bond yields was over too (the peak had actually been passed nearly a year before). By the dog days of August, everything investors thought they had learned in the preceding decades was not worth knowing; now, the first would come in last. Consumer price inflation was falling from a high of more than 10% per year – the index actually hit more than 14% during the month of March, 1980 – down to under 4% by 1984. Bond yields would follow, as investors gradually and reluctantly backed up and turned around.
The pile up of the early ’80s widowed commodities and orphaned gold. But in the next straightaway, stocks and bonds were soon as readily adoptable as a blond-haired boy. By the late ’90s, everyone wanted them. The Dow rose 11 times. Bond prices rose too, as yields fell. And gradually, the roadmaps of ’82 were redrawn. What everyone knew for sure then, they know now was not so. And what everyone knows for sure now is the very thing they knew was false 26 years ago. George W. Bush will leave office with a deficit that would have staggered the generation of ’82 – around $500 billion. But investors know now that ‘deficits don’t matter.’ They expect the dollar to rise and bond yields to fall anyway. Likewise, the stock market was thought to be expensive in ’82; even with shares selling at only 8 times earnings, they considered them too risky. Now, with p/e’s twice as high, stocks are thought to be bargains.
But every generation of automobiles has to find its own way to the scrap heap. And every generation of investors – even those with GPS on the dashboard – has to find its own Deadman’s Curve.
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