A recent article published in Financial Advisor last month (Jan. 31, 2013) quoted a highly successful long-time bond manager Dan Fuss regarding his view of the current state of the bond market:
Dan Fuss, whose Loomis Sayles Bond Fund beat 98 percent of its peers in the last three years, said the fixed-income market is more “overbought” than at any time in his 55-year career as he prepares to open a fund to British individual investors.
“This is the most overbought market I have ever seen in my life in the business,” Fuss, 79, who oversees $66 billion in fixed-income assets as vice chairman of Boston-based Loomis Sayles & Co., said in an interview in London. “What I tell my clients is, ‘It’s not the end of the world, but for heaven’s sakes don’t go out and borrow money to buy bonds right now.’”
It’s that statement, “Don’t go out and borrow money to buy bonds right now,” that seems worth a deeper dive, as this is essentially the mantra that the typical asset allocation model has advised its investors to follow. Based on fund flow data across the mutual fund world, follow they did.
As equity markets were experiencing double-digit rallies, they saw net outflows for 11 out of 12 months in 2012. Bond funds, which returned little in 2012, were a perfect 12 for 12 in attracting new assets (source: Investment Company Institute). And along the way, as Mr. Jones religiously rebalanced his strategic allocation, he “borrowed” from what was working (i.e. stocks) to buy more of what wasn’t (i.e. bonds).
There has been strong institutional interest in “risk parity” portfolios, the roots of which trace back to the more recognizable “Modern Portfolio Theory” and “Efficient Frontier”. Similar to its forefathers, the base idea behind risk parity is that in a typical investment portfolio, equities provide most of the volatility. A risk parity portfolio typically tries to equalize the volatility contribution of different asset classes, which often means reducing the equity allocation—and also often leveraging the bond allocation. This activity is rationalized simply by equating “volatility” with “risk”, as it remains suitable and right in the investment world to refer to many government debt securities as “risk free” investments. Without digressing much further in that direction, “risk parity” portfolios and other derivations of Modern Portfolio Theory find themselves, essentially, borrowing money to buy bonds, the very action Dan Fuss is urging his clients to avoid right now.
Mr. Fuss indirectly spoke to the growing concern that the Bond market may be the latest “bubble” on Wall Street. This may or may not be the case, but if it is, there is very little that a traditional asset allocation portfolio is prepared to do other than continue to “borrow” from other investments to buy the very bubble they unwittingly enabled. A marker of past bubbles has always been irrational behavior. I remember early in my career as a stock broker in the 1970s, it was anything related to Oil that captured the attention of investors. Eventually it got to the point that if something like a publicly-traded hair salon wanted to attract buyers, they had to think about changing their name to West Texas Intermediate Spa & Salon. In the 1990s, most of us remember that suddenly real life earnings became passé, so long as there was a Dot.com at the end of a Company’s name. More recently, the only thing you needed to know about Real Estate was that “They aren’t making any more of it.” In every case, investors borrowed anything they could, from anywhere they could, to buy more of those things long after trends had changed in the markets.
Today an investor can buy all of the 10-year US Treasuries they want with a yield of about 2.00 percent. Yet, the 10-year breakeven yield is about 2.57 percent, indicating that a buyer of 10-year Treasuries expects a negative real return.
Is it rational to buy something with the expectation of a negative return? Think about it this way: Imagine telling a prospective client, “If you buy this stock portfolio, we expect that you’ll lose about a half percent a year for the next decade.” Think you would have any buyers? Would people bid at auction to get a piece of such action? Yet mutual fund data suggests investors continue to buy it as if the government is about to stop “making any more of it.”
Maybe bonds will continue to do well for an extended period of time, and maybe buying with the expectation of a slight negative return will turn out to be a genius move because every other asset class performs much worse. I learned long ago that there is no crystal ball for Wall Street. But I can’t help but wonder how the run-of-the-mill strategic allocation practitioner confronts such concerns with clients, allaying fears of a bond bubble with phrases like “Sure we might lose money on every purchase, but we’ll make it up in volume!”
And so the problem with bubbles is not really that they exist. Bubbles are great for investors and for the economy on the way up. Bubbles often have an evolutionary financial purpose as well — the internet bubble probably laid the foundation for many later businesses. Much of the first internet generation might have died off, but their offspring populate Silicon Valley now. We’ll always have bubbles, human nature being what it is.
The more specific problem with bubbles concerns the investors trapped in them as they deflate, and the absolute impossibility of determining with any precision when that might happen. Trends of all types, including bubbles, can go on for far longer than the common skeptic would ever imagine. Or, to paraphrase words attributed to Lord Maynard Keynes, “Markets can remain irrational far longer than you or I can remain solvent.”
The most practical way to handle markets prone to periodic bubbles, which is every market predicated upon human involvement, is to use some type of trend following tactical approach. You’ll not often find yourself out at the top, of course, but you’ll give yourself a puncher’s chance at participating in much of the ride that comes with the inflating, and a mechanism for exiting before the body blows of a deflating bubble cause extensive damage. I see logical, organized, disciplined applications of Tactical Asset Allocation successfully performed by our professional clients through some of the most harrowing of market environments. Their clients will survive any potential bubble in the bond market because they have a process for admitting when the borrowing costs of the bond market is simply too high to participate.
Tom Dorsey is President and co-founder of Dorsey, Wright & Associates. For over 25 years, Dorsey, Wright & Associates has provided technical analysis research to financial professionals worldwide. Tom has authored numerous books on investment strategy, and is widely known for his expertise in Point & Figure charting and Relative Strength analysis.