Once Again: Are Bonds a Bubble?

What's a Bubble?
Some popular financial phrases have a precise definition. Bear market, for example, has the strict meaning of a stock-market loss exceeding 20%, in addition to the informal sense of "it seems as if every day is down." Similarly, leverage can be used generally to convey a high level of exposure to an asset, or it can be calculated to the percentage point.

Bubble, on the other hand, resists such precision. To paraphrase former U.S. Supreme Court Justice Potter Stewart, as with pornography, a bubble cannot be measured; instead, we are supposed to know one when we see it. Of course, we often see things in different ways. For example, per some critics of the bond market, the U.S. is now in the midst of a bond bubble, while for other critics bonds are not a bubble, they are merely expensive.

This week, Cliff Asness of AQR offered an update on the definition. A bubble, he said, occurs when there is "no plausible defense for a security's price." Thus, technology stocks in 2000 were a true bubble. There was no credible story that could support NASDAQ's peak price of 5000. No matter what tricks one played in attempting to defend the stocks' valuations--and trust me, there are always tricks, always different accounting measures to be selected, different comparables to be used, and different analogies to be made--the numbers didn't work. A company here and there could prove to be a good investment, but the industry overall could not be. For NASDAQ to justify its valuation, every tech company had to become the  Apple (AAPL) of its industry.

I like Asness' definition. It limits the use of "bubble" to the appropriate rare occasions, and it works. Yes, the definition does require strict policing. You can't count Jim Cramer as a plausible defense for a security's price. (Laugh now, but back in the day Cramer was taken quite seriously.) You can't count think tankers who author best-selling books (Dow 36,000) as plausible defenses. You can't count growth-stock managers who are defending their purchases. Bubbles can't be measured by arguments from authority; they are to be measured by the arguments themselves.

And by that standard, the U.S. is notin a bond bubble. There is a real, nontrivial possibility that the U.S. could echo Japan by sinking into a long-term period marked by sluggish growth, stagnating asset prices, low inflation, and low bond yields. (This observation comes from Rekenthaler Who Listens to Economists, as there is no Rekenthaler the Actual Economist.) Asness believes that bonds are overpriced and a poor current investment at today's prices--but he concedes that it's possible he is wrong. So it's not a bubble. 

Staying the Course
Morningstar's Paul Justice forwards me a spreadsheet containing the monthly returns over the trailing 20 years for two funds: State Street's exchange-traded fund  SPDR S&P 500 (SPY) and  PIMCO Total Return (PTTRX). Paul writes, "Portfolios that delivered on conventional wisdom regarding returns. Stocks beat bonds handily, rebalancing worked like a charm, and investors got that 7%+ that financial advisors promised all along. When I see sensationalist fervor emerge, like that PBS documentary showing all those poor folks that speculated like crazy, I like to remind people that this isn't a losers' game."

You know what? He's right. If you had been savvy enough to select the bond fund for the next two decades, the fund that became the world's largest mutual fund due to its consistent habit of outgaining the bond indexes, and you purchased its cheapest share class, you made only 75% of the gains of your schlep neighbor who only knew to buy shares in an S&P 500 Index fund. For your great fund-selection skill, you gained $31,333 cumulatively on a $10,000 initial investment (absent taxes but considering all fund fees). Meanwhile, Doug across the street netted $42,433 cumulatively. This occurred despite the technology sell-off and the great financial crisis of 2008.

Moreover, neither you nor Doug would have been as successful as an investor who knew even less than either of you, so little that he couldn't decide on either stocks or bonds, but instead chose a blend of 60% in the stock fund and 40% in the bond fund. That investor turned a tidy gain of $38,000 for the time period without rebalancing, and $41,220 with rebalancing. The latter strategy provided almost as much total return as Doug's 100% stock portfolio with far less volatility. On an annualized basis, the rebalanced portfolio churned out 8.51% in nominal terms, and 5.69% real. If those were bad times that we went through, bring us some more bad times, please.

Failing Grade
This week I received I received in my email the cheerily entitled media clip, "It's Morningstar That Deserves the 'F'." The headline, found in Canada's Financial Post, is from the Canadian fund association, protesting the F that Morningstar assigned to Canada's fund fees for this year's edition of the Morningstar Global Investor Experience Report (GFIE).

Reword that headline to Rekenthaler deserves the F, as I publish the GFIE Report. No worries. Given that Canada's equity mutual funds check in with a 2.4% annual expense ratio, as measured by an asset-weighted median (meaning that the presumably cheaper big funds count for more in the calculation than do the small funds), it's not as if the GFIE's grade could be too far off the mark. One can reframe and reshape the discussion, as the Canadian fund association does (naturally, the association can't respond, "Yes, Morningstar is correct; our funds are very expensive."), but that will never make 2.4% cheap.

Power Play
Six kilowatt-hours will run a desktop computer for 90 hours, a bright electric bulb for 60 hours, a typical central home air conditioning unit for two hours, or the car that I drove into work today for 18 miles. Riding in a giant glorified golf cart is something different alright. I found myself putting on the radio, because the silence was spooky.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.