Certain safety and eventual death

Cannon to right of them,
Cannon to left of them,
Cannon in front of them
Volley’d and thunder’d;
Storm’d at with shot and shell,
Boldly they rode and well,
Into the jaws of Death,
Into the mouth of Hell
Rode the six hundred.

– Alfred, Lord Tennyson, The Charge of the Light Brigade

Pop quiz!

Your pencil at the ready please. Your question is this: what is greater folly than a charge by lightly armed cavalry against well-defended heavy artillery?

I’ll give you a moment to think.

The answer? Well, one answer at least: recommending that investors “sell everything but high quality bonds”.

That was the conclusion of a much-talked about research report released yesterday by the Royal Bank of Scotland. It got lots of press, as it was probably designed to do. What was the rationale? This from the executive summary:

We have been warning in past weeklies that this all looks similar to 2008. We dust off our old mantra: this is about ‘return of capital, not return on capital’. We suspect 2016 will be characterised by more focus on how the exiting occurs of positions in the three main asset classes that benefitted from QE (other than high quality govt FI, which is cheap): 1) EM, 2) credit, 3) equities. We stick to our -10 -20% equity downside call. In a crowded hall, exit doors are small. Risks are high.

“High quality govt FI”, by the way, is shorthand for government bonds. The report goes on to recommend ten-year gilts, US Treasuries, and shorter-term term German and Italian bonds. The thinking? Well that’s pretty clear: everything else is unsafe. Bonds are safe.

Nothing is safe. Ever. At least when it comes to investing. And in that vein, the sentiment of yesterday’s RBS note is probably right. In 2016, you should be more worried about the return of your capital and the return on your capital. But that bit about bonds…

Since the early 1980s, the bull market in government bonds has been impressive. High quality government bonds are generally considered “risk free”. The benchmark is the three-month US Treasury Bill currently yielding 0.211. It’s not much. But it’s Uncle Sam. And it’s three months. That’s as close to “risk free” as you’ll get in the markets.

But the day of reckoning for bonds is coming. Charlie Morris has shown me a chart tracking bond prices and the S&P 500 over the last 100 years. The chart doesn’t lie. What does it show you?

There was one really good time to sell bonds in the last 70 years (1982, after inflation was tamed and interest rates fell) and there was one really good time to buy them. The time to sell them was in the late 1940s. You had high government debt as a result of the World Wars (two in Britain and one in America, effectively). You had low interest rates.

It was (like today) an era of financial repression for savers. And it was a secular bear market in bonds that lasted decades. Equities were a better bet. The Baby Boomers were born, consumer credit flourished, and big blue-chip stocks rebuilt the world, one middle-class living room at a time.

If Charlie’s right, another secular bear market in bonds is coming. Or, in terms of personal hygiene, bonds (as an asset class) are like a tube of toothpaste in which there is almost nothing left to squeeze out. You might eke out a small gain now. But you risk a massive loss later. And bad breath.

What you can squeeze out will be over the next few months. And on that basis, as a very short-term trade, you might be able to make a bit of money in short-term government bonds. But it’s not the kind of trade you make in order to make money (at least not as an individual investor). It’s the kind of trade you’d make if you were running for your financial life.

It’s also the kind of move you’d make if you thought markets were on the verge of a 2008-style meltdown. You’d be out of equities and commodities and into the most liquid and least volatile asset class you could find.

Direct question: is it 2008 all over again or not?

I’ll get to that in a moment. One last point about bonds. The City and Wall Street recommend bonds to you because it’s what their asset allocation models demand. Some fixed percentage of institutionally managed money (say 15%) almost has to go into bonds. But what if the model is wrong?

Including bonds in a model portfolio becomes a self-fulfilling asset allocation strategy. You buy bonds because the model says so. Not because there’s any value in them. That’s worked just fine since 1982 (and exceptionally well over shorter periods of time). But Charlie reckons it won’t work well at all in the coming years. The point?

As an individual investor, you don’t have to buy bonds if you don’t want to. You should only want to if it’s part of a sensible strategy. And you should only do so when there’s compelling value. Charlie’s put together a sensible strategy which I’ll share with you later this week. It does not include bonds, mostly because there’s no compelling value. It’s not something he could have done working in the City. Now that he’s working for you, he can do it.

Now the urgent question: is it 2008 or not?

PS The “Charge of the Light Brigade” took place in 1854 during the Crimean War. I don’t mean to trivialise it by comparing it to buying government bonds at these yields in 2016. 118 Britons were killed in the charge. 127 were wounded. 60 were taken prisoner. It was folly. It wasn’t heroic or courageous. It was a mistake. And for those who had to follow orders, it cost them their lives. Investing in the bond market now won’t cost you your life. But it could cost you your capital and retirement. There are serious decisions to make with your money this year. That’s why I’m pleased that this week I can finally unveil the project Charlie Morris and I have been working on. Stay tuned.

Category: Market updates