Contrary to very popular opinion and in conjunction with their 30 year bull market, buying U.S. Treasuries could be the best investment of 2011. Few times in history has an investor been able to invest with a major trend and simultaneously be a contrarian. When these opportunities arise, they must not be passed over.
This investment opportunity holds three major drivers. First, U.S. Treasuries hold the benefit of a safe haven during a stock market decline and periods of uncertainty; if they naturally resume their upward trend, any market sell-off could accelerate the upward move. Second, they remain in a massive 30-year bull market; major bull markets tend to continue further than expected and well past traditional valuations. Lastly, buying U.S. Treasuries is a major contrarian play; an overwhelming majority of analysts and fund managers loathe this asset. Rarely does an investor see an opportunity with so many factors simultaneously available: the synergy aspect could be impressive.
This investment view on Treasuries isn’t common. Often professionals and amateurs alike state the following reasons why a continuation of low rates and a Treasury bull market are impossible: government bonds are in a bubble, inflation is just around the corner, the government is a debt junkie with an out-of-control deficit, and the U.S. dollar is going to devalue into oblivion. The data these bond bears lean on isn’t necessarily wrong-they just have the timing incorrect. At some point interest rates will absolutely rise for a prolonged period. It just won’t be right now. So, I don’t disagree with the critics-I disagree with their ability to time the trade.
A Safe Haven
Government bonds are traditionally considered a conservative and safe investment. When the stock market sells off or a crisis occurs, bond prices will rally as investors seek a safe haven. During the recent Japanese tsunami crisis, government bonds around the world advanced quickly. They proved to be a haven during 2008’s financial crisis, during the tech bubble collapse, after 9/11, and after the 1987 crash, as well.
The United States is smack in the middle of a secular bear market, although most wouldn’t know it after a spectacular two-year cyclical rally. When stocks again work their way lower during this secular bear market, growth investors will be looking for returns, and conservative investors will be looking for yield and/or a vehicle to preserve capital. U.S. Treasuries seem to be the most obvious vehicle to satisfy both types of investor. Treasuries played this role like clockwork during the last two stock market declines in 2000-2003 and 2007-2009. With yields at almost 4.5%, 30-year Treasuries are actually quite attractive from a yield perspective, as well.
Using current earnings, the P/E ratio of the S&P 500 stands in the top 10 percent of all historical valuations. Poor stock market performance always follows historically high P/E ratios. Data shows the average 10-year inflation adjusted return following a top-10% valuation period as an entry point is less than -8%. At this point in time, stock market investors should certainly expect sub-zero percent returns over the next decade.
30 year Bull Market
“The trend is your friend until it bends in the end.” This cliché about markets is dead on. U.S. Treasuries are in a massive 30-year cyclical bull market. Yes, it may be nearing the end of its life; it just is not quite there yet. The interesting quality of long-duration markets (either up or down) is that they typically blow right through reasonable valuations before ending and reversing. Reasonable valuations can help one get into a market initially but historically will get an investor out of an investment too early before the market reaches an absurd valuation (like Facebook.com currently being valued at over $70 billion?). The point is that relying on fundamental data such as inflation or government deficits at this late stage of the bond bull market is almost a waste of time in regard to timing the end of the move.
Even if I’m wrong about fundamental valuations being useless at the end of a cyclical bull market, it is clearly evident that there are numerous historical precedents for higher bond prices. Here in the United States, 10-year government bonds saw a low in yield of about 1.5% in the 1940s, and Japan saw a low for the 10-year JGB at about 1%. The current U.S. Treasury yield stands at 3.65% and a bond value of about 119. If the U.S. 10-year note falls to a yield of 1%, the bond price will rally to over 140-a massive 17% rally. To put that trade in perspective, if the MKC Global Fund assumed a standard conservative position size in the 10-year note and yields dropped to 1%, our fund as a whole, not just the individual trade, would earn about 18%.
The most blatant aspect of the bond trade is its contrarian quality. To say I hold a lonely view is an understatement. I know of only two major fund managers who prefer to buy U.S. Treasuries instead of shorting them. For example, recently CNBC hosted one of the many individuals preaching the idea of shorting U.S. Treasuries. This man is the chief investment officer for a firm that manages $2 billion, and he was quite vocal about shorting the asset. Fortunately, there is nothing special about this since seemingly every day CNBC and Bloomberg interview individuals with identical views.
Parting company with the crowd is never comfortable. Luckily, the logistics of a contrarian investment are quite simple. If the vast, vast majority of market participants hold the same view and is subsequently on the same side of the trade (in this case own zero government bonds or short them), any movement in the assets price away from those participants will result in their sustaining losses and unwinding their positions. It’s comparable to betting the underdog (that’s actually a superior team) in sports and receiving points.
Lastly, Bill Gross, who manages Pimco’s $257 billion Total Return Bond Fund, made a bold move by reducing the fund’s holdings of U.S. Treasuries to zero. He sold them all. That is a dramatic stance, and the market will punish him for it by running up Treasury prices and forcing him back into the market at higher prices. He has a slew of high-profile advisors, including past Federal Reserve members such as Alan Greenspan. These people help tremendously in determining the fundamental valuations for U.S. Treasuries. But, as shown earlier, that fundamental information is useless at this stage, and an advisory board of that caliber can only be for show.
Bill Gross certainly isn’t alone. Other major market players who are either short U.S. Treasuries or maintain a negative view and won’t buy any time soon include: Warren Buffet, Marc Faber, Jim Rogers, Nassim Taleb, and John Paulson. Again, these are only a handful of individuals, but they collectively manage more than $300 billion. It is unknown how much capital Marc Faber, Warren Buffet, and Jim Rogers influence with their financial views.
Buying U.S. Treasuries should prove to be a profitable investment. Certainly, nothing is a guarantee, but the risk reward ratio for this asset is heavily skewed in the proper direction. Investors face an investment environment where, starved for yield, they have been forced to speculate in stocks. When stocks begin to decline, Treasuries will become their asset of choice. The contrarian component of this opportunity only creates a more exciting scenario for investors, as long as the masses don’t incorrectly convince them otherwise.