What to Watch For in Treasuries

If you are an advisor to individuals or a person who has interest with investments or planning, there is no better person to give insight than David Loeper.  With permission, I am sharing today’s article with you.

Enjoy.

By David B. Loeper, CIMA®, CIMC®

“Belief in myths allows the comfort of opinion without the discomfort of thought.”

– John F. Kennedy

 There has been a lot of talk lately predicting the demise of US Treasuries. But it is crucial to understand that much of this talk is not founded on evidence, rather it is based on the myth that one can forecast where the stock market and interest rates are heading. At Wealthcare Capital Management®, we don’t forecast anything other than uncertainty, because being wrong can hurt our clients, and we won’t bet our clients’ lifestyles on those forecasts.

 Even the experts don’t get it right. For example, The Wall Street Journal periodically surveys leading economists on their prediction for the movement of the Ten Year Treasury. Of the 57 economists surveyed in October 2010, the average forecast for the Ten Year Treasury yield was 3.55% by the end of this year. The lowest forecast in this survey was 2.5%. At the time of this writing, the Ten Year Treasury is yielding 2.02%.

 Wealthcare Portfolios contain Treasuries because they act as diversifiers when the equity markets decline. Historically, over any twelve month period from 1926 through 2010, stocks produced a negative total return 26.6% of the time, while the 7-10 year Treasury index produced a negative total return 14.8% of the time. But, they simultaneously produced a negative total return only 3.9% of the time. This is one reason why portfolios blending stocks and bonds are more efficient than portfolios made up of just one.

When Standard & Poor’s reduced the credit rating of US Treasuries in August, we were concerned…concerned that perhaps the portfolio protecting effect of Treasuries may have come to an end, but so far, there is no data to support that.

A DECADE OF BEING EARLY

 Experts have been forecasting the imminent demise of US Treasuries for more than a decade. I remember a lunch I had back in the summer of 2001 with an old friend who is a financial advisor. The Internet bubble had burst in the spring of 2000, and we were in the midst of a bear market in stocks. The 10 year Treasury yield had declined from over 6% to 4.5% over that period, a level not seen since 1967, other than a brief period near the Russian currency crisis in 1998. He thought we were “nuts” to use 7-10 year Treasuries in our portfolios. He was also sure that interest rates had to go up from here and that longer maturity bonds would decline. “Besides, the bear market was over a year old and clearly stocks would start to come back over the next year,” he confidently claimed. By the summer of 2002 stocks declined about another 20% and the yields on the 10 year Treasury had declined to 3.6%, producing significant gains, not losses. Yields had not been that low since the early 60’s. Despite this, by June of 2003 the 10 year Treasury yield continued to decline to a low of around 3.1%.

My friend believed the myth that he could forecast where the stock market and interest rates were heading and how long a bear market would last. He was wrong, and it cost his clients dearly. From the start of the bear market in the spring of 2000 through June of 2003, the S&P500 was down more than 25%, the yield on the 10 year Treasury dropped from over 6% to 3.1% producing a total return of over 47% for the 7-10 year Treasury index. The advisor participated in the equity decline, even increasing the equity allocation well before the bear market was over and didn’t participate in most of the upside of Treasuries, all based on his myth.

Stocks continued their recovery from the summer of 2003 through October of 2007, appreciating 58%. Treasuries yields rose back up to 4.7% over this period, and even though they produced a positive return in each calendar year, there were some 12 month periods during this time when their total return resulted in a loss of as much as -3.8%.

 Of course the markets were devastated in 2008 with a 38% decline in stocks, but the flight to safety produced 17% total returns for the 7-10 Year Treasury index. The stock market in 2009 bounced back with nearly a 29% gain, and the 7-10 Year Treasury index lost 6.4%. Treasuries also behaved as expected during the flash crash of 2010 and the third quarter of 2011.

MONITORING THE SITUATION

 We are constantly monitoring the extent and frequency with which the Treasuries misbehave relative to how we model them. In our humble acknowledgement of the continuous uncertainty of the markets, and our steadfast avoidance of risky timing bets to protect our clients and their ability to achieve their goals, you might ask if we would ever change our position. The answer is absolutely, yes. But this decision won’t be based on anyone’s risky market timing forecast; it will be based on evidence. When it comes to Treasuries, we would be forced to replace them in our portfolios with the next best thing (which isn’t very good), IF we had sufficient evidence they no longer behaved as we had modeled them.

 For example, if we had a long term bear market in stocks and Treasuries declined significantly more frequently than they had historically; that would cause me to question whether their fundamental behavior has changed. Or, if the markets started to price Treasuries with yields that were higher than quality corporate bonds; that would cause some significant doubt, which may trigger a change. If we had several severe stock market shocks and Treasuries declined more frequently than they had historically, we might change our perspective as well.

We keep our eye on the relationship between equity and Treasury price changes every day. While we were fearful of the rating downgrade and continue to be concerned about the amount of debt the Treasury keeps accumulating, we have not seen any evidence that the behavior of Treasuries has fundamentally changed.

The lower Treasury yields go, and the more debt the US Treasury accumulates, the more forecasts we will hear about the imminent demise of Treasuries. Eventually, Treasuries will decline and it isn’t a matter of if, but when. But we don’t know when, and obviously the economists don’t know either. There is a cost to the risk of trying to time the markets, as anyone who has made the bet on shorter maturities or on other assets has witnessed over the last decade. Market timing is risky. Both lengthening or shortening Treasury maturities and over or underweighting stocks subject you to the risk of underperformance, increase uncertainty and expand the range of potential outcomes. These are risks you can avoid with certainty by avoiding such market timing bets.

 Understand that all those who have been forecasting that Treasuries yields will rise and prices will fall will eventually be right. It could be next year or it could take another decade or more. We don’t know and no one else does either. We just admit it, while they gamble on it. Needless gambles are not the way to confidently exceed your goals.

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A popular industry speaker and writer, DAVID B. LOEPER is the CEO and founder of Financeware, Inc. in Richmond, VA. He is author of the top selling book Stop the 401(k) Rip-off!, three other books released in 2009 by John Wiley & Sons (Stop the Retirement Rip-off, Stop the Investing Rip-off and The Four Pillars of Retirement Plans) and numerous whitepapers. He has appeared on CNBC, CNN, Fox Business and Bloomberg TV, served on the Investment Advisory Committee of the $30 billion Virginia Retirement System, and was chairman of the Advisory Council for the Investment Management Consultants Association (IMCA). Before founding Financeware in 1999 he was Managing Director of Strategic Planning for Wheat First Union. He earned the CIMA® designation (Certified Investment Management Analyst) from Wharton Business School in 1990 in conjunction with IMCA.

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This writing does not constitute a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. It is intended as general information. Illustrative data used in the presentation regarding market, asset class or other investment returns or other investment statistics, including average investor returns, is from sources believed reliable but not verified independently by Wealthcare Capital Management®. Wealthcare Capital Management’s disclosure document can be found at www.wealthcarecapital.com/ruminations/WCMADVII.pdf or upon request at e-mail compliance@wealthcarecapital.com.

http://wealthcarecapital.com/

http://www.amazon.com/Stop-Investing-Rip-off-Avoid-Victim/dp/1118133064/ref=sr_1_1?ie=UTF8&qid=1323354885&sr=8-1

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About Christopher Hessenflow

Christopher Hessenflow is a financial planner in the Chicago area. He works with all sorts of people who are much more interesting than he is. He enjoys his career which lends him time to think and, sometimes, be creative. Chip was born bald.
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