In the second quarter of 2023, equity markets continued moving higher, while bonds were lower, as evidenced by the Barclays US Aggregate index ending down -0.84%. It was another rude surprise for high quality bond investors, marking the fourth quarter of negative returns in the last six. Losing money has been the exception in bonds since the start of the US bond bull market in 1981, with four out of five quarters seeing positive returns during that span.
On a variety of occasions over the past few years, we have warned that a combination of low starting bond yields and significant interest rate risk, also known as “duration,” made some high-quality bonds especially susceptible to losses. One of the bull cases for equities has been the acronym “TINA,” which has stood for “There Is No Alternative” to investing in stocks, because bonds’ low starting yields implied that ongoing deflation would need to prevail if bondholders were to continue eking out returns; sustained deflation is not a feasible outcome in the US for a variety of reasons that we will leave for another time.
At this point, the “TINA” case for having a minimal allocation to bonds no longer holds. Capital has a cost again, with two-year Treasury notes yielding just under 5% as of this writing versus the latest annualized inflation numbers running at half that. While bonds are interesting again, the “TINA” acronym may now be valid for equity sectors other than tech, which trades at a 3% earnings yield in a year when analysts project barely over 1% growth in the group’s earnings per share. Indeed, the tech sector trades at a valuation multiple premium1of 60% today versus the market, which is a level last seen in conjunction with the tech collapse over twenty years ago.
Of course, one should have a much stronger case to bet heavily on a collapse than “last time relative valuations were here, bad stuff happened.” Valuation and past precedent do not augur the future, or investing would be a simple exercise. None of this stops people from making all kinds of useless forecasts and predictions based upon simple correlations and limited sample sizes. For instance, Bloomberg publishes a “US Recession Probability Forecast,” which is the median forecast probability of recession over the next year taken from dozens of Wall Street pros. That number is currently 65% — a scary number, no doubt, until one considers the recent track record of the indicator. It registered a scant 25% at the end of February 2020 and soared to 100% at the end of April 2020 as COVID lockdowns brought economic activity to a halt. The National Bureau of Economic Research has since reviewed this time period and put official start and end dates on the recession, which began in February 2020 and ended in April 2020. Said differently – economic forecasters found it very unlikely that a recession was pending when it had already begun, and they predicted a 100% probability of a recession after it ended and none was forthcoming. The retort of soothsayer fans might be, “But it was COVID, it was a different kind of recession!”
Every economic and investing environment is unique. A top point of concern today is the yield curve, portions of which have been inverted for a year now. Inversions have occurred before many recessions, and the thinking goes that when long-term rates fall below shorter-term rates, the short-term rates will eventually need to come down to offset a slowing economy. Understanding the applicability of reference classes is among the most critical components in generating excess returns. Perhaps the most underrated reference class is what happens most of the time – human progress continues. Monetary policy makers know more about the economic machine than ever, and they have a wider set of tools at their disposal to implement policy. Perhaps most importantly, a recession is the opposite of the Fed’s mandate. We are emerging from a unique period in economic history, so it would make sense for events without precedent to continue occurring in markets. One event might be a deeply inverted yield curve without a recession.
When people wring their hands over the shape of the yield curve and what it could mean for the economy, they are neglecting other powerful indicators. Homebuilders are breaking out and approaching all-time highs at the same time that mortgage rates are spiking to multi-decade highs. This is not because consumers are fearful; it is because they are optimistic about the future and making a massive commitment to it. Real hourly wages are again growing for the first time in over two years, which implies more purchasing power for those who need it most and are likely to spend. The VIX recently closed below lucky 13, a level not seen in over three years. The headline inflation number is at the lowest level in over two years after twelve consecutive declines. If the Fed’s tightening indeed tips us into a recession, it is a pretty easy fix to start the printing presses again.
Of course, we do not make forecasts or try and predict the future in constructing the portfolio. We look to own businesses and bonds whose prices do not fully reflect their earning potential.
We are on the prowl daily for securities whose prices we find appealing. As always, we remain the largest investors in our strategies, and we appreciate your support while welcoming questions and comments.
Bill Miller IV, CFA, CMT