How Bonds give bigger returns (or losses) than you expect

 I posted on March 3rd, I am buying bonds!  I am 52 years old, and been an active trader (on and off) since 2006.  Until recently, I didn't see the upside value to bonds.

People hear that a 30 year bond yield is 2.4%, and say, that's a terrible deal to lock up all that cash for 30 years.

The trick is, you don't have to hold bonds for 30 years, you can sell them at any time, just like a stock.  This matters as the value of a bond can materially increase or decrease based on current interest rates.

Let me give you an example I bought $31,595  at a rate is ~2.4 % for a 30 year payoff. Terrible right? Such a terrible deal! Lets look closer!

So assuming I never sold, my total net paid back would be $64,632.23 in 30 years.

On 7/19/2021, the going rate for 30 year bonds was 1.81%  If you purchased $31,595 worth for 30 years, you would get $54,247.48 , that is a $10,384.75  difference!

So lets take a look at what happened to my bonds.

Above is the stands on my purchase, below is the current 'market value'

Up 18.5% from March 3rd to July 19th, a gain of 18% in 5 months, not bad!

So why did the value change?  Well since new bonds go at 1.81%, and what I purchased had a yield around 2.4%, My higher rate yields a premium to buy my bonds.  If I was to sell the bonds at $32,000, since I have held them only 5 months out of 30 years, you are getting a great deal! As going to buy from the government pays only 1.81% vs what I have at 2.4%

When you buy bonds the value of the bond today either yields a premium price or a discount based on current rates.

Lets say I sold this to you for $37,463.40, and you held it for 30 years at a rate 1.81%,  you would get $64,323.31.   That is Pretty darn close to what I would get after 30 years quoted above, $64,632.23 in 30 years.  its only off by 300 bucks!   The difference has to do with 'spreads' when buying bonds on the open market, you don't get the exact price that its worth.

So there ya go, I can sell these bonds, pocket 18% interest in 5 months and go buy stocks if I want.  Or I can hold for 30 year to go to 1%, which I think it may.  What will this be worth? It depends on when.  if rates hit 1% 29 years from now, the value won't change.  if its tomorrow, then the value will be up an additional $6,000, for a total of up $11K on a $31K investment, up 34%.

As you can see, when the stock market is topping, and we have a 'risk off' event, if you are in bonds early enough, you can get material gains when everyone else is down materially in investments.  At that point you can sell your bonds and buy stocks (or crypto) at a huge discount.

An alternate to buying bonds is buying TLT, and ETF that mirrors most of the valuations I showed here.
TLT is based on 20 year treasury, not 30 year, so the 'compound valuation' isn't as long as buying a direct 30 year bond.   I think TLT will hit a new high in the next year, at the same time the stock market will lose 10%-40% of value.  

In March the low was 134, its now at 150, and the high is 170.   From low to high will be a 26% gain.  From here a 13% gain.

Lastly, if your are a crazy gambler, TMF is a leveraged ETF based on bond yields.  In march it was $21.83, Monday it was up to $31, basically a 50% gain.  Since its leveraged, it will lose some value over time due to the multiplier costs.  So its a bit better for a trade of 1-3 months than years.

Good luck, I hope you now understand that Bonds are not as boring as you thought, there is risk of up or downside based on interest rates.

Market action 7-19-2021

The Russell 2000 has broken the uptrend in place since March of 2020.

If it breaks below 2034 on a closing basis, the Russel will have broken out of the trading range in place since January 2021.

The expected low points to buy for a turn around is at 2042, 1834, 1666, 1498.

My gut says we will get a bounce around 2042-2034, and come close to new highs before failing down to 1834.  But quite a bit depends on Republicans allowing free money to flow to the people with the debt ceiling deadline of July 2021 and various spending bills proposed by the Democrats.

Target is 10% loss in market

 The chartists I follow expect 10% loss here through August, a potential rally thereafter.   

My conclusion  is the same as last week.  We have severe headwinds for continuing free money.  The Republicans will tank raising the debt ceiling, and fight against extending free money.  If all free money ends, I do not believe full employment is possible back to circa January 2020 simply due to all the failed businesses.

Therefore the real economy is worse off than the stock market valuation shows.

The market  last week hit the most extreme distortions on many fronts never seen in the history of the US stock market.   If those indicators predict future returns accurately, we will see negative returns in the market in the decade ahead.

I don't think it will pan out that way, simply because the central banks and US government will step in.   But to step in, we need hard times to justify new powers of meddling in the tatters of capitalism.  Buckle up.  I hope bitcoin hits close to 15K, as I will re-load the boat.   Gold is not good until we get the next leg up in free money at earliest.  

Bonds, cash is king.  If your selling your house, get er done!

The euphoric market

 The market will continue to advance, until it doesn't.  If history repeats, there will be a correction.

Money Creation

First, lets get straight how money gets into the USA economic system. Money is created exclusively by the banking system, not the government.   Banks can create money by creating credit.  How does the government get money? By banks buying US government debt notes, US treasuries.

If money is created by credit, how do banks finance bank notes?   When there is cash in the system (deposits and can be money markets), banks record cash as a liability.   To offset this liability it purchases US treasuries to offset these liabilities.

Therefore the only way more money is created is via banks.  Therefore if the banks slow down in credit creation, there is a slow down in money expansion, and usually money velocity slows.

Is there any bank warning signs?

Revoking Private Credit lines

Well Fargo is revoking all private credit lines.  In a growing economy with a year of boom ahead, this would not make sense at all.  It only makes sense if the bank has concerns over credit lines being repaid.

Bond Rates

In an inflationary environment, bond rates rise, however bond rates are falling.  Why do rates fall? Rates go down when buying debt at a lower rate is a 'good deal'.   If the future outlook is great, then money flows to better returns.  In the Federal Bond market, there is a distortion however, as the US government has not been issuing new debt, but instead spending its 2 trillion dollars created in 2020 through bonds issued then.  

Federal Reserve reverse Repo - up 1 trillion in ~3 months

Even so, there is an appetite for bonds, so much so, that the US federal Reverse Repo market has shifted from 3 billion over night in April 2021 to recently 1 trillion.  See the Fed's graph to appreciate how dramatic this is.

The risk here is if the Fed changes the Reverse Repo arrangement, there will be a dramatic run on US bonds, further driving down rates.

Most money losing companies in US history, coupled with highest market in US history

In 94 years, largest percent of companies losing money annually with an historic high in the stock market.

Projected future market returns

Given current over-valuations, if we use financial history over the last 94 years as a guide, the normal expectation is the US stock market to yield -5% in market value in the 12 years ahead.  If this does come to pass, it is quite logical the market goes materially lower (50% or more?) before we return to new highs.  First here is the distribution chart expectations.

Second, if we use Japan as a guide for trying to use the government and central banks to 'expand the economy' through quantitative easing and accommodative banking, lets look at how their market did. Over 30 years with a lower stock market.

Who is buying all the stocks at this level?

The number of new trading accounts in the past year set records.  Did you know that 'margin' trading has been given to many of these accounts?   It is thought many people who lost their jobs, been handed free money, have 'found' a better job, trading.   Margin can double or triple your earnings....or losses!  None of these trader experienced a market freefall.

To keep Margin rates adjusted for the size of the US economy over time, John Hussman graphed it as a % of GDP, right now US Stock market is 3.5% of the US GDP! Quite impressive and concerning if people are forced to sell due to margin calls.  While this isn't a problem with a market rise, it is fuel for a  market panic if the market takes a hit.

Did you know the stock market hasn't touched the 200 DMA since June 2020?  The market must lose 11% to hit this.  Nice video on this.

Free money to the people

I stated in this blog back on December 2nd, 2020, "If the government decides to resume mailing checks directly to Americans, then all best are off, the stock market will be fine and the economy recovers in record time.  "

And although I doubted Republicans allowing the free money train to continue, I was wrong, it did!  And look at the result, the stock market did quite well.  The question of course is, has the economy recovered?  If you go to NYC or any large US city and walk around its not even close to the way it was in 2019.  Further small businesses have failed in record numbers, with new jobless claims still in the 400K range for any given WEEK!  

I know that the jobless claims are blamed for the free money checks creating a society unwilling to work.  Even if true, do you really believe if the free money train ends, that all the people who are living off of the free money will immediately find a job paying equal to or more than the free money quickly?

If not, no matter how you cut it, our rosy economy depends on free money to make it look good.  If it ends, the reality hits, and if it continues all we are doing is kicking the can.  The market will stop levitating if the free money ends.

What could end the free money train?

There are two areas that weigh on me trying to believe a smoother market heat.

First requires believing that the Democrats requiring Republican votes will lead this nation to a robust economic recovery.  The US debt limit suspension ends July 31st.  Unless 10 Republicans vote to raise the debt limit or continue the debt limit suspension, the US government will start a very quick march to a default.   There is some wiggle room, but if pressed, we could see the first US default in world history.   I don't think Republicans will hold out and force a default.   But I can't rule it out, further I expect they demand ending the free money train to approve the government spending limit suspended or raised.

Second is to have faith that the Federal Reserve board made of 6 voting members can steady the global economic ship into smooth sailing without a mis-step.

If the free money train zooms along, I am not convinced we will see a major market correction.  Once the free money ends, its on the table.  A 10% isn't major, we are talking 33% or more.

What to do?

Pay off debt, diversify, and having 25-50% in cash to weather a potential storm.    

Investing in US bonds/ETF  TLT (US government bonds).  Rates typically plummet in a run from risk to safety.  TLT can easily rise another 20% from here.  A gambling play is TMF, which could double these returns.

For income stream "JEPI" etf promises to seek high dividends by actively managing underlying investments.  I particularly like also diversifying to India, there are many ETF's.  One of the larger ones is INDA.  However I expect INDA and JEPI to devalue with the market, but I have hope they recover much quicker.

Other ways to diversify is Bitcoin/gold, but both of these should see materially lower levels before higher levels.