The Boyar Value Group has historically been good at identifying financial bubbles. Like most value investors we are early in our prognostications but in the end we are usually proven to be correct. This was the case with both the internet bubble and the real estate bubble. We have been discussing that there could be a Treasury bubble for quite sometime, and up until recently except for some minor fits and starts we have been proven wrong at almost every turn. With the recent dramatic rise in interest rates, could this be the start of something big? Below is an excerpt from an article that appeared in The Financial Times in March of 2012 which we included in our 1st quarter 2012 letter to Boyar Asset Management clients.
All things must pass. Treasury bonds regarded as the world’s safest assets have been in a bull market (meaning their prices have risen while their yields have fallen) since 1982. Equities have been in a secular bear market (with falling prices) since 2000. Neither can last forever. It is possible in the future, when looking back we will see that both have already ended.
Just recently a number of well respected economists have made such a prognostication. In support of the thesis relating to bonds it is argued The Federal Reserve will not undertake another round of quantitative easing. The U.S. economy shifts to a sustainable recovery, private sector credit in the U.S. expands, China and other major emerging economies rebound after dipping in the first half of 2012 and the eurozone recession doesn’t shock the global economy.
If all of these conditions are confirmed, then a bond bear market, with lower prices and higher yields, is inevitable.
Naturally, none of these conditions is yet certain. But let’s assume that bonds are indeed in a new bear market; how will this affect equities? It should be good. Money coming out of bonds must go somewhere. Most pension plans and individuals have abandoned the equities markets in droves in favor of bonds. A change in asset allocation could fuel a further advance in stocks.
From a historical perspective bull markets normally commence when equities are very cheap, rather than when the economy is strong. There is no question that stocks are significantly more attractive than bonds. You can still purchase high quality equities where the yields are significantly higher than bonds. Furthermore, in a great many instances the dividends, in all likelihood will be raised multiple times during the next decade.
One can certainly make the argument that equities only look attractive because bonds are overvalued, and their yields are unsustainably low. If bond yields were to rise, so the argument goes, then equities may outperform in relative terms, but wouldn’t rise in absolute terms.
In response to the aforementioned position one must remember that the correlation between rising bond yields and equity prices is not constant, but changes according to the levels of the yields. When yields are low, a rising yield does little damage to the economy or companies’ borrowing plans. But above a tipping point of 4 to 5 percent, higher bond yields begin to entice investors away from stocks, and begin to negatively impact a company’s ability to capture an adequate return from the borrowed money…all potentially damaging to equities.
With yields starting out at historic lows, plainly an initial move would be positive for stocks.
Ten year treasury bonds currently yield 2.2 percent. They could rise quite awhile before troubling the stock market.
So, where does this leave us? A turn in bonds would be initially great for stocks, which theoretically can be a refuge for the displaced funds. This big switch has not as yet occurred, but at some point in the not too distant future there is a good chance both equities and bonds will shift their secular direction – probably at much the same time. The critical driver is the economy.
However, the economic data does not yet prove the secular shift is imminent. And once the shift has happened, equity investors need to be very careful that bond yields do not race upwards raising the cost of money and crimping the valuations they can pay for equities. The vast majority of bond traders working today have known a world in which yields forever come down, so there is a danger, however, remote this could happen, once it becomes clear that bonds’ long bull market is over.
Boyar’s Intrinsic Value Research LLC prepared this posting as a matter of general information. We do not intend it to be a complete description of any security or company. All facts and statistics referenced herein are from sources we believe to be reliable, but we do not guarantee their accuracy and it may be incomplete or condensed. Boyar’s Intrinsic Value Research LLC makes no commitment to update this posting and it may remove it at anytime from its website. This posting represents the views of Boyar’s Intrinsic Value Research LLC as of June 19, 2013 and may change without notice.
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