Bonds Are Up Nearly 40% In The Past 9 Months - There Is Still More To Go
EPB Macro Research
While most of the media and analyst attention has shifted towards the equity market and the large declines in stocks, the bigger and more profitable move has been in the Treasury bond market.
Over the past nine months, the 10-year Treasury rate has plunged from a rate of 3.25% to 1.72%. The 30-year Treasury rate has staged a similar decline which translates to a nearly 40% rise in long-duration Treasury bonds such as ETF (EDV).
I have been bullish of long-term Treasury bonds, highlighting the opportunity in ETFs such as (TLT) and (EDV) for over a year based on the expected deceleration in economic growth and the research on why economic cycles matter.
In a recent note on why cycles matter, which you can read by clicking here, I highlighted seven "up cycles" and seven "down cycles," the seventh which we are currently still in as outlined by the data below.
The cycles, defined using the IHS Markit Global PMI and several factors such as the length of the decline, the magnitude of the decline and the breadth of the decline are outlined in the chart below. Down cycles are from points A to B and up cycles are from points B to A.
We can test the performance of various assets as we did in the previous research note during each up cycle and each down cycle. The results are overwhelmingly clear.
If we look at the return profile of 30-year Treasury bonds across up cycles and down cycles, the results are stunning. When the economy is accelerating, Treasury bonds decline as you'd expect.
During down cycles, when growth is in a phase of deceleration, Treasury bonds soar with an average full cycle return of +25%, greater than 30% better than the S&P 500 during down cycles.
For months, while Treasury bonds were rising, popular analysts were constantly making the case against Treasury bonds, ignoring the research that shows long-term bonds rise with a 100% positive hit rate during economic cycle downturns.
Now that long-term bonds have rallied nearly 40%, and the move in rates is undeniable, as is the trending direction of economic growth, the narrative against bonds has shifted to one of exhaustion - rates have moved too far too fast.
Those who did not anticipate the decline in rates are now suggesting the move should be over but they are making the same critical mistake as they did during the missed decline in rates - they are ignoring the economic cycle.
Instead of focusing on those who missed the move in bonds, I am going to tackle this from another angle.
The move in the economic cycle is now undeniable, a move that was spotted over a year ago in both our long leading and short leading indicators. The major question now is whether it is too late to join the rally or if it is time to cash in the major profits.
This is a logical question. If I am sitting on 20% or 30% gains in the long bond, how do I know when to exit the position?
The answer is simple. The economic cycle. As long as the economic cycle continues in a down cycle, it is premature to declare the move in long-term bonds to be over.
Before having a firm understanding and a leading indicator process to spot economic cycle turning points, it was always difficult to decide when to exit a position.
Using economic cycles and a combination/confirmation process of both long-leading and short leading indicators, the asset allocation, positions and outlook shifts when the economic cycle shifts.
Several weeks ago the rally in stocks allowed some to claim that bonds were an inferior investment choice, even in a downcycle.
Well, even though I dislike year-to-date measures, long-term bonds are now outperforming stocks (SP500) by nearly 7% year-to-date.
The more important way to measure performance is from cyclical turning points. The last cyclical inflection point, noted in the global PMI chart above, occurred at the end of January in 2018. Over the past 18 months, you could have been positioned for a down cycle, generating over 20% gains in two preferred allocations at EPB Macro Research, long-term bonds, and utilities.
Over 18 months, which is far from a day trade, investors in stocks have made 2.77% after dividends while bond investors, ridiculed for the investment, have earned over 20%.
Now, consistent with the average historical returns based on the research of cycles, bonds are outperforming stocks during this down cycle, as we'd expect.
So, will this rally in bonds continue? Should you jump in now or sell some of your gains?
How you risk manage your portfolio will always remain a personal preference.
What I can say is that the process that allowed us to make this call on rates, stemming from the forecast on economic cycles in growth and inflation, suggests this economic down cycle is not yet over, which means there remains a high probability that the move in rates is not yet over.
As long as the growth rate cycle continues to trend lower, the playbook remains the same.
The easiest way to use the leading indicator process is to be long of cyclical equities during up cycles and shift to overweight bonds and defensive equities during down cycles. It also makes logical sense and can be done in both tactical accounts and your more long-only passive accounts. Aggressive during up cycles and defensive during down cycles.
How will you know when the economic cycle turns and when to exit positions or change the outlook?
Forecasting economic inflection points can be done by monitoring baskets of economic data that both logically lead in the economic sequence and have empirically led the economic cycle throughout history.
At EPB Macro Research, in addition to studying secular economic trends and business cycle trends, we are hyper-focused on the short-term growth rate cycle or the 12-36 month fluctuations in growth that drive the majority of your investing returns.
When analyzing these shorter-term cycles, we use a combination/confirmation process of several leading indicators, separated into two baskets: longer leading data and shorter leading data.
Longer leading data turns as much as 12-18 months before cycle turning points, followed by shorter leading data with moves that can be 6-8 months before downturns and 3-4 months prior to upturns.
By measuring long leading data, and having it confirmed by short-leading data, a high level of conviction can be gained before a cycle turning point and a pivot in asset allocation.
The long leading indicator graphed below, one of several long leads we use, outlined this current down cycle over 12 months in advance of its inflection point.
After the long leading indicator has inflected, we then start to get hyper-focused on a variety of shorter leading indicators that turn next in the sequence.
Below is a shorter leading index of the US ISM manufacturing PMI.
As both charts show, without a sufficient upturn in either the long leading indexes and without confirmation in shorter leading data, the call for this economic "down cycle" remains and the allocation to defensive sectors over cyclical sectors and bonds over stocks remains firmly intact.
At EPB Macro Research, once an inflection in longer leading data is identified, which is then confirmed by shorter leading data, a cyclical turning point is declared and the allocation shifts to stocks over bonds and cyclicals over defensives.
When investing across cycles, you can reduce your fear of having to be in the S&P 500 at all times or risky equity sectors by identifying the assets that perform well during a down turn - there are many of them including some sectors of the stock market.
Knowing the economic cycle, which you will virtually all the time with a combination of long-leading and short-leading indicators, is the biggest tailwind to have at your back when making investment decisions.
Knowing the direction of the economic cycle is the best way to maximize your upside and minimize your downside risk. The biggest risk to your portfolio always happens when you are on the wrong side of the cycle.
Investing with the direction of the economic cycle, using the cycle as a tailwind, will improve your long-term results. During down cycles, equity volatility, growth scare induced drawdowns and "shocks" are common and should be expected. By understanding the economic cycle, not only could you avoid the equity market volatility, you can position in assets that have massive upside with significantly less downside during down cycles, such as Treasury bonds.
If you are a macro-based investor, having a leading indicator approach coupled with the analysis of relative performance during up cycles and down cycles will allow you to significantly increase your chances of being positioned in the best sectors while avoiding the laggards.
401k investors will be alerted when to shift assets or reduce exposure to stock funds in favor of bond funds.
Even if you are an individual stock picker, your hit rate, or probability of success will be increased dramatically by identifying the correct sectors from a macro standpoint, based on the trending cycle, and narrowing your basket of stocks to select from.
Having a process that involves long leading, short leading, and coincident economic data, coupled with the historical sectoral analysis during each cycle of growth and inflation will help to dramatically improve your investing results and dramatically improve the conviction in your portfolio.
Based on this process, the rally in bonds is likely not over. Over the next several quarters, lower bond yields are still probable.
As long as growth and inflation continue to decline, which the leading indicators still suggest, bond yields will continue to make new lows.
Start Using The Economic Cycle To Your Advantage
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