Today, we take another look at what we think is the most overpriced asset class, at least in US dollar terms. That asset is long-term government bonds.
Even as long-term US Government bonds hover at historic and all-time highs, investors seem there think there is value in the securities. Long-term bond investors do not seem to care about the current rate of inflation. Nor do they seem to care about the potential for inflation driven by historic federal government deficits and unprecedented asset purchases the Federal Reserve.
When the government shut down the economy, they had to do something to help with the average family that was put in a position where they could not go to work, earn a paycheck, and pay their bills. So the Federal government addressed one misguided policy by putting forth another misguided policy. That policy was to send people money, whether they needed it or not. To compound the error, they decided to bail out shareholders and wrote checks to companies the government put out of business. The government did not have the money in the bank to do such things fo course, so they borrowed it. The Fed was ever so accommodative, bought the debt, $3+ trillion, which was more than the Fed Gov collected in tax revenue, by the way, making the financial world numb to the economic dislocation the Fed Gov Health & Human Services implemented.
The issue is not if the government’s massive spending and the Fed’s asset purchases did not get us over the hump. We are sure the shot of epinephrine did the job. The issue is the long-term effects. While many of us were spared the pain of government policy, our children and grandchildren will pay the bills the Fed Gov racks up today.
At some point in time, people will not be willing to buy government bonds that pay 0.5% in an environment where the inflation rate felt by the average person is running at 3-5% or maybe even higher. Introduce a tax rage of 30+%, and we see bond investors are guaranteed to lose 3.6% [(3%-0.5%)/(1-30%)] of their purchasing power every year.
We think that long-term government bonds are arguable the most overpriced asset class in the history of humankind. The same overvaluation extends to corporate bonds. The following chart compares the yield on AAA bonds relative to yield on the S&P500.
Yields on AAA-rated corporates, relative to dividends, have never been lower. No wonder companies borrow money and buy back their stock. These low rates make it far easier for managers to increase EPS by buying back stock than expanding production or introducing new products.
We have suggested a bearish position on long-term government bonds from time to time on these pages. Some of those trade worked, and some did not. Given the manic behavior of the market, we sit on our hands and wait for a time when maybe, just maybe, investors come to their senses. Perhaps that time is now.
The gold price is telling us that some investors are losing confidence in the Fed Gov and the Federal Reserve. But is it not just the precious metals players thinking twice about the USD. The Bitcoiners are getting energizes. Bitcoin got close to $12,000 and pulled back to $11,000. It is acting like the path to least resistance is higher prices.
But what about the price action of TLT, the ETF that tracks long-term US government bonds. We think it is looking a little sickly.
We may finally be at a time when a selloff in bond prices (a rise in yields) is at hand. TLT could fall from the upside trend line and chop it way down to the middle or lower end of the trend channel. TLT could fall to as low as $125 and still be in bullish mode. But, we expect the bulls to fight any bear trend. So if this scenario plays out, we expect the selloff to be slow but relentless. That being the case, we think the best strategy is a straightforward one. Buy an out of the money, long-dated put. With TLT trading at $165.21, consider the following option.
We chose a March $160 strike put in this case as we want to catch a big swing, should it manifest. The price of this put is $6.50, which is 3.9% of the underlying value. The breakeven level is $153.50, which is 7% below the current price. If this were a short duration option, we would have concerns. But seven months is plenty of time for a big selloff to manifest. The probability of profit is just 32% if we assume a random walk. Since bonds tend to move in cyclical waves, we think the chance is much higher than that, if the next down cycle is about to manifest.
