Tuesday, February 21, 2012

The Important Point From the Hugh Hendry Interview in Barron's

Which we agree with:

"The road to hyperinflation is via hyperdeflation. That is why it’s proving so difficult for hedge funds to make money. How does the rational mind that anticipates hyperinflation own 10-year government Treasuries yielding less than 2%? It can’t. That’s why people are struggling. To lay the seeds of hyperinflation, you need really, really bad things to happen."
That was why we made the - ultimately correct - long Treasury bonds call starting two years ago. We are now neutral on Treasuries.

As I've pointed out before, there is a huge divergence between Treasury yields, which are still low, and the equity markets, which have rallied significantly off of the October lows. One theory is that Treasury yields are "artificially" depressed, either by Fed intervention or by the flight-to-safety bid, and that there are significant risks to owning Treasuries if the equity market is in fact correct this time. Technical "analysts" point to a "double top" in the Treasury bond.

And it is true that the earnings yield on the S&P 500 has the biggest spread ever over Treasury yields.

Is what we are experiencing a false recovery like the one we saw last year? Or, is there significant pent-up demand for consumer durables like automobiles?


Stagflationary Mark said...

For what it is worth, I'm in the false recovery camp. I'm basing it primarily on this.

Anyone basing future returns on past results really needs to factor that in.

That's not to say that we can't grow from here. I just don't see a growth rate similar to what we've done historically. Worse, that's just one headwind out of many. It is not my only exponential trend failure chart. Failure isn't so bad though unless one can prove that we'll never return to the former trend line, which I can. It's impossible.

At least I know my inflation protected TIPS suck going forward. Fortunately, I locked in higher rates while others were sitting in short-term debt. All it takes is basic math to know that a 0.7% long-term real yield sucks. In that regard, I share your lack of enthusiasm for long-term treasury bonds now. I continue to hold them just the same.

Perhaps that's the allure of the stock market right now. It can be rationalized that good times are coming back and the treasury market is, as you say, "artificially depressed". It's funny though. I wasn't buying because the Fed was buying. I was buying in spite of them. It was like we were competitors and we both wanted the same thing.

It was never my intent to buy TIPS ahead of the Fed and then later sell them to a greater fool for a profit. I was and am just fine holding to maturity. Go figure.

Stagflationary Mark said...

Bonus thought.

If I lose my nest egg due to a misplaced bet in inflation protected treasuries then heaven help the stock market. It isn't like investors there will be safe.

There are only two main ways I can lose over the long-term.

1. We default outright on our debt. In my opinion, that would mean that the economy is doing so poorly (and the stock market with it) that I simply cannot be paid what I am owed. Could happen.

2. There is so much inflation that the limited inflation protection that my TIPS offer is not enough. I have to pay tax on the inflationary gains each year. If inflation is 20% or more, I'd feel serious pain. I sure don't see how stock market investors would enjoy that environment. Warren Buffett referred to inflation as a tapeworm in his 1970s shareholder letters. It continues to eat regardless of the state of the host. Perhaps the stock market can rise in nominal terms but I strongly doubt it would rise in inflation adjusted terms (any more than it could in the 1970s).

Many seem to think I will lose if the economy strengthens and real yields rise. That's true on paper but not in practice. I root for that outcome. I hold to maturity anyway. A strong economy means that I can rule out the two ways I could be financially ruined.

That said, I'm not betting that real yields rise due to a strengthening economy. It would very much surprise me if it happened.

CP said...

Agree on the false recovery.
Disagree on the TIPS. I would sooner short them than own them.

Stagflationary Mark said...

For what it is worth, real yields can get worse.

If you do short TIPS it is something to consider. I just don't think our economy can or will ever support high real yields again over the long-term. The growth won't be there.

Just an opinion of course, and some would argue a pessimistic one at that. Time will tell.

Stagflationary Mark said...

Here's a relatively safe arbitrage.

Buy the 0.0% I-Bond. Hold 5 years.
Short a 5-Year TIPS bond. Hold 5 years.

Before taxes, that's free money. Anyone buying short-term TIPS but not buying I-Bonds first is just throwing money away.

I buy I-Bonds every year. I can't say the 0% real interest rate is great, but it is "relatively" great, lol. Sigh.

I've yet to cash one in. The ones I bought in 2000 (3.4% over inflation) have doubled.