A momentary lapse of reason
March 31, 2012
Market Summary – 1st Quarter, 2012
The world experienced two traumatic market declines in the last twelve years that erased trillions of dollars of personal wealth and adversely altered the lives of millions of Americans. Comparing the bursting of the dot-com and housing bubbles, it is easy to believe that they were each caused by very different issues. However, the root cause of each bubble remains the same. Investors blindly purchased these assets, regardless of price and fundamentals, based solely on the premise that they would be able to sell these assets later to someone else for a higher price. These momentary lapses of reason may be profitable in the short-term, but ultimately this voracious speculative appetite subsides, sellers cannot find buyers, and prices collapse.
We currently stand at the precipice of another asset bubble, this time in U.S. Treasury bonds. Similar to the housing bubble, investors believe that U.S. Treasury bonds will be a safe investment at any price. The notion that U.S. Treasury bond prices can decline is unknown to many investors, as falling interest rates have been driving bond prices higher for 30 years. But just as real estate was perceived to be a safe investment because many investors had never lost money in it, investors will soon again experience the painful lesson that no investment is safe if bought at too high of a price.
Current U.S. Treasury bond investors are overlooking three crucial shortcomings: they are historically expensive, they can go down sharply in price, and that the loss of purchasing power caused by inflation is almost certainly greater than the interest that today’s bonds will pay investors.
The risks in the U.S. Treasury market are not limited to the direct owners of U.S. Treasury bonds. Many bonds, corporate bonds being the most well known, have interest rates that are effectively tied to the yields of U.S. Treasury bonds. Therefore, most bonds also offer meager yields on a risk-adjusted basis, and are subject to the same price decline risks as U.S. Treasury bonds.
Bonds are a Historically Expensive Asset Class
A U.S. Treasury bond with a ten-year maturity currently offers a yield of about 2%. In other words, an investor who purchases a single $1,000 U.S. Treasury bond will only receive $20 of interest income per year. To demonstrate how meager this yield is, one should think of interest income as the equivalent of the bond’s “earnings” and consider that the Price-to-Earnings/Price-to-Interest Income of a bond is an astounding 50 times – a modern day high valuation1. Most rational investors would not consider paying 50 times earnings for any kind of investment, let alone for one that offers little to no price appreciation and whose interest income/dividend cannot increase over time.
Many risk-averse investors, in an effort to insulate themselves from geo-political and economic uncertainty, have abandoned interest income for the sake of perceived safety. Unfortunately, this perceived safe investment is anything but safe.
The Return of Mr. Market’s Wild Ride
The notion that bond prices can only go up reeks of the same naïveté that fueled the housing bubble, and commits the tragic investment error of taking the current state of the market and extrapolating it into infinity without viewing it in the appropriate historical context.
Since the United States left the gold standard in 1971 and interest rates began to float more freely, the average yield on a 10-Year U.S. Treasury bond has been 7.12%. If interest rates revert to this historical average, the price of a current 10-Year U.S. Treasury bond will decline by over 35% – a loss greater than that experienced by the average United States homeowner from the housing bubble’s peak through today.
We are not suggesting that interest rates will go back to their historical average in the immediate future. However, we do believe that the current 70% discount to historical average interest rates will begin to move back to normalized levels as central banks around the world try to manage their over-levered balance sheets and excessive unemployment levels. If rates double to return to 60% of their historical average, the price of a current 10-Year U.S. Treasury bond will still decline by 17%.
The summer of 2011 market swings were unsettling to many investors, as the Dow Jones Industrial Average experienced numerous days of 250 point drops and by the end of the third quarter had declined by 12% in just three months. This market volatility shook investor confidence, grabbed headlines, and even prompted us to write a special newsletter to address investor concerns. While we do not want to sound like Chicken Little by declaring that the sky is falling, we suggest that if investors took a 12% stock market index price decline seriously, then a potentially much greater loss in the bond market needs to be taken even more seriously.
But Won’t I at Least Get My Money Back?
Despite the weak outlook for U.S. Treasury bonds, investors are still buying bonds because they believe that at the very least they will receive their money back at maturity. While it is true that investors who purchase a U.S. Treasury bond with a ten year maturity for $1,000 will receive their $1,000 back in ten years (along with the aforementioned $20 per year in interest income), the true value of this $1,000 ten years later is far less due to the wealth-eroding effects of inflation. Given the inflation rate of the past ten years, the returned principal of $1,000 has only $800 of purchasing power – and this is during a decade with relatively low inflation! To put this number into a more personal context, this percentage decline is approximately the amount that home prices in the United States have declined since April of 2008.
As the following table demonstrates, inflation has eroded the dollar’s purchasing power by a staggering 82% since the United States went off of the gold standard in August of 1971. While bond investors argue that over the past ten years inflation has been below its historical level, this muted inflation rate is still much greater than the interest income provided from the current low yielding bonds.
We believe that the Fed’s dual mandate will likely cause inflation to be greater than what we have experienced over the past ten years. This dual mandate calls for the Fed to not only control inflation, but also to promote full employment (an unemployment rate of approximately 4%). At times, these mandates conflict with one another and the Fed must balance the relative extremes of each objective. The current unemployment rate of 8.2% is well in excess of the Fed’s targeted full employment rate, and inflation is generally in-line with the Fed’s objective. Therefore, it appears likely that the Fed will continue to promote economic growth and lower the unemployment rate at the expense of higher inflation. This will surely lead to greater loss of purchasing power in the future.
Sell and Regret . . . but Sell First!
Nobody can predict when the bond market bubble will burst, and we recognize that these low yields may persist and even drop further in the short-term. However, from an investor’s perspective we believe that the table has been set for significant disappointment for bond investors. Now is a good time to take your bond winnings off of the table, and allocate your funds into undervalued asset classes that offer you a materially better risk-adjusted return profile. Successful investing is predicated on capitalizing on opportunities when they are inexpensive and then watching them appreciate in price, not buying what is currently popular (and expensive!) and then watching it fall in value.
The Best Asset Classes for Increasing Purchasing Power
It is important to remind ourselves that the purpose of investing is to increase purchasing power. For most of us, investing is a necessity in order to pay for future expenses, be it for education, medical bills, retirement, or personal luxuries that we desire. The meager interest income that one receives from U.S. Treasury bonds is insufficient to provide for these items, particularly when considering the negative effects of inflation.
In assessing today’s market conditions, we see tremendous value in two productive asset classes: distressed real estate and equities. These asset classes not only have the ability to deliver cash flows that will retain their purchasing power in inflationary environments, but also are inexpensive by historical standards.
Depressed real estate is attractive for the same reason that bonds are unattractive. While the dangers of being a fixed rate lender in an inflationary environment are great, there are significant benefits to being a fixed rate borrower in an inflationary environment. However, most investors lack the resources to be a successful real estate owner-operator. Furthermore, even fewer want to deal with the associated headaches! It requires physical labor to maintain a property and manage tenants and cash flows. In addition, most investors lack the capital to acquire and manage a diversified portfolio of properties. Other risks exist in acquiring shares in real estate partnerships. Perhaps most important, real estate is an illiquid asset class.
The case for equities is more compelling. As we discussed in our last newsletter, the balance sheets of the United States and European countries are in poor condition, and these nations will need real economic growth in order to trim their deficits. Policies are needed to promote growth. The beneficiaries of these policies will be multi-national corporations that create and provide needed, and not easily duplicated, products and services.
To demonstrate the value and opportunity that exists in equities, consider the following:
· Equities are still cheap: The trailing Price-to-Earnings ratio of the S&P 500 Index is 13x, approximately a 15% discount to its historical 15x average. However, this 15% discount understates how inexpensive equities are on a historical basis. Low interest rate environments promote economic growth and improve the profit outlook for corporations. These improved growth opportunities increase the value of equities, which should be reflected through valuation multiples that are above the historical average. Therefore, one can argue that today’s Price-to-Earnings multiple discount is particularly pronounced and effectively greater than the computed 15% figure.
· Recovery in equities is occurring without full investor participation: For the twelve months ended February 2012, the S&P 500 Index managed to increase by approximately 3%. However, it was able to achieve these gains with over $150 billion leaving U.S. equity mutual funds and $160 billion going into U.S. bond funds during that same time period. In other words, the U.S. equity market has been able to achieve positive gains with one hand tied behind its back as investors have fled to non-equity investments. When investors overcome this momentary lapse of reason, money should flow back into to U.S. equities and should help drive prices materially higher.
· Equity indices growth is lagging economic growth: While the S&P 500 Index has not yet recovered to levels that it reached in 2007, global GDP has increased by approximately 15%. Given that approximately 50% of the revenues for U.S. companies in the S&P 500 originate from overseas markets, it becomes clear that investors have not yet rewarded equities for the global economic growth achieved over the past few years.
· Equities offer comparable income to long dated U.S. Treasury bonds, while still providing both price appreciation opportunities and inflation protection: The dividend yield of the S&P 500 Index is 1.98%, comparable to the yield of a 10-Year U.S. Treasury bond. Meanwhile the Dow Jones Industrial Average sports a dividend yield of 2.58%, more than one-quarter greater than the 10-Year U.S. Treasury bond. Along with generating dividends that are comparable or, in many cases, superior to bond yields, stocks are currently better positioned to outpace inflation than bonds.
If you believe (as we do) that equities are positioned to outperform other non-productive asset classes, your next goal should be to maximize your opportunity within equities. While the equity market as a whole is positioned to appreciate materially, we respectfully remind investors that they should aspire to outperform the market, not to meekly surrender and accept average results.
We all know that not all companies are equal. At MPMG we believe that companies that carry low valuations, produce differentiated products for the global economy, have healthy balance sheets, and are operated by world class managers are best positioned to create great wealth and help investors reach their financial goals.
There is no instant gratification in creating long-term wealth. Given how expensive bonds are at this time, investors need to recognize the important role that equities play in the preservation and growth of purchasing power throughout their lives. The fact that common sense does not seem very common in the investment world today is not unusual. These momentary lapses of reason are not only the key factor in the proliferation of asset bubbles, but also the source of great investment opportunity. The seeds of prosperity need to be planted well in advance of the harvest so that they have sufficient time to grow.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.