Dec 31, 2009
Market Outlook: One Contrarian Call for 2010
By Andrew Mickey, Q1 Publishing
“Buy and Hold” is Dead.
That’s what a U.S. News & World Report headline declared last December.
At the time markets were down, everyone was scared, and many were calling the end of “buy and hold” investing.
As it turns out, it couldn’t have been more wrong. Odds are that anyone who bought and held anything since then came out ahead. Ironically, the longer they held, the greater the gains.
As we enter the New Year though, the situation is much different. There’s no obvious contrarian bet to make. Just try and think of something that hasn’t done well this year?
There aren’t many extremes in the market. There’s not much bearishness. There’s not much genuine bullishness either. The markets have rallied strongly and no one knows for sure what will happen in the year ahead.
The one thing we can probably count on though is this year will not turn out to be another “Buy and Hold Anything” kind of year.
One contrarian opportunity, however, is showing the first signs of an uptrend. It’s been one of the best performing investments over the past two years, it’s at a multi-decade extreme, and has all the fundamentals in place to make it one of the most profitable opportunities in the years ahead.
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An Equal and Opposite Reaction Awaits
The market rally has astonished many. Even we have to admit it lasted longer and went higher than we originally expected.
Of course, over the years we’ve learned to not fight it and simply “take what the market gives you.” Those lessons proved immensely valuable throughout the rebound.
But here we are, nine months into an aging rally, and almost everyone now realizes what the real drivers are (excerpted from March 5th Prosperity Dispatch):
- Stocks in general are reaching much more reasonable valuations
- Short sellers (betting the markets will go down) are starting to run out of opportunities
- The trillions of dollars governments around the world are pumping into the system…will likely spark a soft recovery – at least a temporary one
The combination of low expectations sparked the initial part of the rally and cheap money kept it going longer than most anyone expected.
Now, it looks like the policies that fueled the rally are creating an equally profitable opportunity as the market reacts to them.
The End of an Era
As contrarians, we have to look for extremes in the market. Whether it’s extreme highs or extreme lows, both present the opportunities for the highest reward.
One of the few extremes is in U.S. government bonds.
The chart below shows the yield on the 10-year Treasury bond over the last 50 years:
It doesn’t take long to see that interest rates are at extreme lows. The last time they were around this level was 50 years ago.
At that time, however, the U.S. government was in a much stronger financial position. Total U.S. debt was $290 billion. Medicare and Medicaid liabilities weren’t even created yet.
The economy was on very solid footing as well. Unemployment was under 6%. The baby boom was winding down and the wave of new, productive workers were about to enter the workforce.
Altogether 4% seemed like a decent rate of return in exchange for the risk of lending to a fiscally sound government backed by a strong economy.
A lot has changed since then. Debts, deficits, unemployment, and demographic fundamentals are all headwinds for any type of lasting economic recovery.
On top of that, the central banks of the world have committed to printing money as the preferred “solution” to the crisis.
The thing that hasn’t changed is the required rate of return to lend to the U.S. government. The world still considers 4% to be a reasonable rate of return.
It’s only a matter of time until a greater rate of return is demanded. And it’s likely to come sooner rather than later.
Bernanke’s Bind
When the Fed Chairman started slashing rates in early 2008, we pieced together how Bernanke’s short-term “solutions” were going to have disastrous consequences. And unwinding everything is going to be nearly impossible. Here’s why.
The recovery, the stock rebound, and the commodity run, are all based on low interest rates. The Fed has slashed short-term interest rates to near zero. It has also managed to keep long-term interest rates low. The Fed’s unprecedented step of officially buying U.S. government bonds and mortgage backed securities has successfully kept long-term interest rates low.
The Fed has flooded the markets with money by buying assets from banks and giving them freshly printed money in exchange.
So the banks have a lot of cash. And, as time passes and banks are more comfortable making loans, they’ll start making them, the money supply will increase dramatically, and the Fed will be forced to take action to prevent the resulting inflation.
This creates what we have called “Bernanke’s Bind.”
Eventually, inflation will be an issue. Investors will sell Treasuries and push up interest rates. Meanwhile, the Fed which takes out money from the system by selling Treasuries will have to sell the bonds to reduce the money supply.
In addition to that, the U.S. government is going to be selling them too. The U.S. government has to roll over more than $2 trillion worth of them in the next two years. Also, the federal deficit should add at least $1.5 trillion from there.
At some point in the not too distant future, everyone is going to be selling treasuries at the same time. Since interest rates move inversely to bond prices, everyone selling bonds at the same time pushes the interest rates on them way up.
As a result of all this, the Fed will be forced to choose between bad and worse. Option A - Reduce money supply, drive up interest rates, and kill the recovery. Option B – Let inflation run its course and let 10%+ inflation kill the economic recovery.
It doesn’t matter which one they choose, interest rates will go up.
The One Risk
Everything is lining up for interest rates to rise and bond prices to fall.
U.S. government bond yields are at 30-year lows and there’s only one way for interest rates to go.
As with all speculations though, there are risks. In this case the risks are minimal.
As I told Prudent Investing readers when we positioned ourselves to profit from the virtually inevitable rise in interest rates, “[If the] U.S. government cuts spending and hikes taxes, the economy continues to grow, Medicare gets sorted out, a compromise on Social Security is reached, and a solution to the coming state government pension and budget crisis is reached, [interest rates will likely stay low].”
To me, that’s a “risk” worth taking.
In the end though, we’re at a point where almost no one sees inflation, higher interest rates, or the Fed’s predicament on the horizon.
Many investors are still betting the low-interest rate party will be here for a long time. If history is any evidence, it won’t be.
That’s why I recommend looking to bet on rising interest rates in the coming year. Rising interest rates could start to really appear next year or the year after. But in five or 10 years, it’s tough to imagine a situation where we look back at this period and think interest rates weren’t at extreme lows.
There are no clear contrarian indicators like a major magazine predicting “New Era of Low Interest Rates” or something along those lines, but it’s a pretty safe bet there’s only one way for rates to go over the long-term. And that’s up.
Hope you have a happy and prosperous New Year,
Andrew Mickey
Chief Investment Strategist, Q1
Publishing
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