Juggling Dynamite

Richard Bookstaber offers some useful insight into present financial conditions and behaviours in this segment.

On this episode, we speak with Richard Bookstaber, a veteran of numerous firms, having done risk management at Bridgewater, the University of California, and elsewhere. He’s also the author of the book A Demon Of Our Own Design, which prophetically warned about financial system fragilities in the run-up to the Great Financial Crisis. He’s currently the co-founder of Fabric, which provides risk management technology to the financial industry, and he spoke with us about where he sees the biggest risks right now.  Here is a direct audio link.

The fact that long Treasuries have kicked the pants off the S&P 500 in total returns over the past 40 years is one of the best-kept secrets in finance.  Indeed, looking for a publicly available chart that reveals this is like searching for a needle in a haystack.  But then, a so-called investment sector that profits from encouraging the masses to click, borrow, trade and gamble with corporate securities and derivatives have no interest in spreading the truth about investment returns.

Still, math is math, and those with access to the correct historical data and enlightenment can see it.  In September 2019, Gary Shilling offered a rare public reveal explaining why he was bullish on long-term bonds.  The article included the chart below, which graphs the total return of the 25-year zero-coupon Treasury bond since 1981 (in red) versus the S&P 500 total return (in black) beginning in 1982 (at the start of the longest and strongest secular bull market in history).  Here we can see that a dollar invested in the long bond grew to about $32,000 while a dollar invested in the S&P 500 grew to about $6,000.

Total returns always assume that every dollar of income is reinvested as received.  So, in real life, any income or principal withdrawn by the owner or paying investment fees will reduce realized compound returns over time.

Extending from the chart above, Treasuries continued to outperform stocks dramatically from July 2019 to August 2020.  Stocks had a better short-term gain from late 2020 to last month, but Treasury’s have retaken the lead since.   With stocks presently the most over-valued, over-hyped and over-allocated in history, Treasury returns are due to run leaps and bounds ahead of equities once more.  It is a tragedy that so few people understand these basic facts.

As I have explained many times, the finance industry charges the richest fees, packaging and promoting corporate securities (equities and corporate debt), as well as real estate and commodities.   Because these assets tend to rise with inflation and fall with deflation, the bias inherent is to forecast inflation and further price gains, regardless of valuations or market cycle.  High yield or junk debt is also high-risk and thus traditionally has to pay higher yields to attract buyers.  For this reason, it also pays fatter fees to the financial sector, which helps companies issue and sell this debt to the public.

On the other hand, government bonds are an institutional product used by pensions, insurance companies, foundations, and the most sophisticated high-net-worth investors.  They do not need to pay high fees to the finance sector for retail marketing or distribution.

As a result, most financial folks have a bias against government bonds even though on a total return basis, they have outperformed stocks (S&P 500) by 3.5 times since 1980, with much lower volatility and capital loss risk.  They are also one of the few assets that can offer negative correlation/diversification benefits when other asset markets deflate.

Case in point, as commodities, high yield bonds and equities have been plunging of late, North American government bonds have been rising with the U.S. dollar.  These moves are typical of periods where growth and inflation expectations (at a lag) are falling.  The chart below, courtesy of The Daily Shot, shows the downward yield trends during past Fed tapering “Q.E.” efforts.
Even more than usual, portfolio managers and retail came into the latest risk-off selling with the highest concentration of equities and the lowest weight of bonds and cash on record, all while being the most levered ever.  Ditto for CBOT traders who were massively net-short Treasuries in October.

All of this helped lay the conditions for a sharp rebound in treasury prices (falling yields).  U.S. 10 and 20-year yields have moved back to levels seen in February and March of 2020. The Treasury market is not buying the inflation hype and is pricing weaker growth and deflationary weights in 2022.

The discussion below explains what only those of us ‘paid to see’ can acknowledge.

The Federal Reserve, and other central banks, buy tremendous amounts of government securities and this should impact bond prices. Should, but doesn’t. That’s because there’s an even more powerful force than the Fed, the bond market itself. We review the 2007-19 evidence.  Here is a direct video link.