Bond. James Bond. Those words were Sean Connery's first line as 007 in 1962's Dr. No. When the first Bond picture came out, 58 years ago, the investing world was a very different place, with information confined to daily newspapers and share ownership concentrated among a few. Can you guess what the yield on the 10-Year U.S. Treasury note was in 1962?
The answer to my question is not 6%, 8% or 10%, but a more pedestrian 4%. The benchmark 10-year UST yield hovered around that figure during the Kennedy Administration after staying below 3% for the early half of the Eisenhower administration and breaking out in the late 1950s. The U.S. civilian economy entered a period of rapid growth in the 1950s after being crowded out by wartime spending (with correspondingly low interest rates in the 2%-2.5% range) during the World War II years. That spike in rates was unabated until the cigar-chomping legend himself, the recently departed Paul Volcker, killed the inflation dragon with his monetary shock treatment during the first Reagan Administration in 1981-1984.
Since then it has been a steady decline in the 10-year UST yield from 11% to today's 0.59% in the span of 35 years. A quick look at the long term charts shows that the 2000-2001 tech implosion, 2008-2009 financial crisis, December 2018 pullback, and 2020 Covid Crash were ALL preceded by a pronounced move upward in the yield on the 10-year UST. Yet, none of those short-term reversals in interest rates have broken the long-term trend lower. The problem now is that, at 0.59%, we can't go much lower on the UST, so that tailwind is abating.
So really, this era of stock appreciation has been aided by portfolio managers' gains in the bond market, not caused by them jettisoning bonds in favor of stocks. Anyone who has ever toiled over the Capital Asset Pricing Model knows that a lower discount rate produces a higher present value for any stock. Moneychimp's return calculator shows an 11.43% average annual total return (including dividends) for the S&P 500 over the 1985-2019 period, with about 2.8% reduced annually owing to inflation.
But there is no inflation now...right? We have a Federal Reserve that is constantly tilting at the windmill of deflation. A return to Moneychimp shows the extraordinary injection of funds into the U.S. economy. At year-end 1984, the U.S. money supply, as measured by M2, stood at $2.311 trillion. The most recent reading for M2 was $18.424 trillion. That produces a 35.5 year CAGR of an astounding 6.0%.
More than half of the returns in stocks over the past 35 years can be attributed to the torrent of money being released in the U.S. economy. That's why bond returns haven't lagged stock returns by as much as you might think. The iShares long treasury bond fund, (TLT) , has a 7.81% annual return since its inception in 2002. Not too shabby.
Again, though, the strong returns in BOTH bonds and stocks have been driven by the extraordinary injections of money into the U.S. economy by the Fed and Treasury. That trade is aging rapidly. There is a limit to the extent that interest rates can decline. I don't think we will ever see negative rates on the 10-year UST because that would effectively bankrupt most pension funds and annuity style investments.
I return to James Bond and the lessons he learned in 1964 when he was chasing Auric Goldfinger to Fort Knox. There is a time for gold and other hard assets and that time is now.
Metals that have industrial uses -- like the automotive uses for platinum and palladium -- are even more attractive than gold. I sold some silver this week, after waiting years for that metal to perform, but am working on converting those hard-earned capital gains into new positions in even shinier metals.
Cheap money and low interest rates produce high valuations for stocks -- today's forward P/E of 22 on the S&P 500 is just a few clicks away from the 2000 peak -- and that inevitably leads to crashes. Powell and Mnuchin have created another bubble in their response to the Covid-19 crisis. It's always difficult to see one when inside one, but you should be diversifying away from financial assets and to hard assets to mitigate the risks of that bubble's inevitable burst.