For most of 2010 Treasury bonds have been a very good investment. Sure, they haven’t paid much in interest but with yields falling, Treasury bond prices have been climbing. And so the gain on the iShares Barclay 7-10 Year Treasury ETF, which tracks the price of seven to ten year Treasuries, was 12.7% from January 4, 2010 through October 11. Plus interest.
Sure beats the 2.9% gain on the Standard & Poor’s 500 Stock Index for the same period.
No wonder money has flowed out of stock mutual funds and into bond mutual funds for most of the year. And out of equities and into bonds in general.
But you’ll notice that I stopped my performance numbers more than a month ago. Since then the trend in medium-term Treasuries has been down. And that trend has accelerated recently. From its peak on October 11, 2010 at $100.08 the Barclay Treasury ETF has dropped to $96.92 on November 18. That’s a drop of 3.5% in a little more than a month.
That kind of performance, obviously, makes Treasuries a much less attractive investment. A decline of a month in duration isn’t enough to change opinion among bondholders. It’s simply not long enough. But if that downward move ascends to the level of a trend in the minds of investors, then I think we’d see some of the money that flowed into bonds and bond mutual funds start to flow into stocks and stock mutual funds.
What might delay the transition from event to trend is that the decline in bond prices is so counter-intuitive. (Fancy talking’ for It don’t make no sense.) If the Fed is buying Treasuries, and particularly targeting these maturities in an effort to get interest rates down, shouldn’t the price of these bonds be going up?
Well, yes, unless bond investors are convinced that the Federal Reserve’s new program of quantitative easing is going to work. If the Fed’s efforts are actually going to be successful and stimulate growth in the U.S. economy, then growth and inflation will both pick up and bond prices should indeed head downward. That’s the logic that has driven up yields on 30-year Treasuries in the weeks after the Fed announced QE2 in early November. And the logic that has Paul McCulley, a portfolio manager at PIMCO (Pacific Investment Management) telling Bloomberg that “The grand super secular bull market is essentially over.”
That’s almost certainly right—sooner or later. But in the short run the conclusion isn’t inevitable. If the bond market decides that the Fed’s solution will work, then interest rates won’t go down and QE2 won’t deliver the desired stimulus.
That would leave the heavy lifting in the U.S. economy to the wealth effect as a climbing stock market lifts confidence among consumers and CEOs.
And those who think that the Fed’s real game is to engineer a stock market rally as a way to get the economy growing again would have turned out not to be cynical but correct.
creativekev,
Thanks for the compliment. I’m no Jim, but he’s definitely influenced me.
If you’re curious about my original ABT pick, note that I bought on May 25th, before Jim. That’s why my target price is for next May. I may revise it upwards before then if the price approaches $58 and if the conditions warrant a revision. I posted my buy and target price in a comment on Jim’s blog:
https://jubakpicks.com/2010/05/25/update-thompson-creek-metals-tc-4/
Also note that, in another comment on the same post, I gave my advice to treat the correction as a buying opportunity. Basically, the same advice about trying to time the market as I gave in my response to salmoned.
USDAportfolio,
Great answers supporting your preference for ABT – and thanks for sharing! I can see you’ve done your homework, and not only that, I agree with your reasoning, including your preference for a “bird in hand” advantage. If Jim’s thesis is correct that the first half of 2011 will see the US stock market give back some of 2010’s gains, then you don’t want to take chances on some future “advantage” that hasn’t materialized yet. I also agree with investing in a defensive sector like health care. All in all, you’ve done good analysis, used clear reasoning, and disclosed your assumptions – and in doing so, you’ve come close to Jim Jubak’s high standards. Feel free to keep sharing your opinions!
Thanks, southof8.
I’ll give five quick reasons I prefer ABT to MRK. First, my understanding is that MRK is going to have more headwinds from patent expirations over the next few years. While that doesn’t mean that MRK can’t simultaneously develop new drugs in the future, I like knowing that ABT has a relatively secure “moat” in the near term (as opposed to hoping for future drug development and approval). In this case, it’s a “bird in the hand” philosophy…
Second, from some of the research I’ve done, I like ABT’s management decisions and methodology. One illustration is the decision to buy Piramal, which demonstrated a clear-thinking and future-looking strategic mindset. There have been other things I’ve read about ABT management that I like. I am simply not familiar with MRK management. Like sports, in a “head-to-head” comparison of two similar teams, a good coaching staff can prove to be the difference.
Third, the FCF-yield of MRK, by my calculations, is between 3.75% and 4%. This is less than that for ABT.
Fourth, I have seen both Mr. Jubak’s and Morningstar’s target prices for ABT, and they are both above my own, which gives me confidence in my analysis. I haven’t seen either for MRK.
Finally, there are some things I don’t understand on MRK’s Income Statement and Statement of Cash Flows. Perhaps there is a good explanation, but I don’t know the answer behind them, and that personally makes me hesitant. I’m not willing to take the additional time to research when I have a very good alternative investment option with ABT.
MRK could still be undervalued, and if they demonstrate that they can continue to develop their drug pipeline to replace (and exceed) losses due to patent expirations, I think MRK could easily trade in the mid-40s. I’m not saying it’s a bad investment, just giving my logic behind a preference for ABT.
USDA, awesome answer. Thanks. Why do you prefer ABT to MRK? After buying schering plough at the bottom of the market amidst all the panic, I’ve been of the mind it’s the big pharma to own.
Have you done an analysis on MRK similar to the one you’ve done on ABT?
salmoned,
I own ABT, T, and DD.
I’m not suggesting that you buy ABT. Only you can decide if a stock like ABT deserves a place in your portfolio.
That said, if you are looking to add to your healthcare exposure (which I am), ABT has a very good story. Compared to other big pharma plays, they well protected from near-term patent expirations. ABT management demonstrated their wisdom by using the strong dollar earlier this year to buy Piramal, which will facilitate long-term growth. They have a nice dividend yield (3.7% beats the yield on the 10-yr treasury bill) and a solid record of increasing dividends.
By my calculations, their free cash flow yield is greater than 4.5%, which is better than the yield on the 30-yr treasury bond. Investors preferring fixed income will use this number as a basis of comparison when fleeing bonds for stocks, and in this category ABT is a “trade up” in yield.
Additionally, by my calculations, ABT is undervalued, and my personal target price for next May is $58, which leaves room for a 22% capital gaiin. My target does not account for added demand from bond investors fleeing bonds. Note that my target price for ABT is below both Mr. Jubak’s and Morningstar’s.
Finally, healthcare tends to be a defensive sector. So, in addition to benefitting from bond outflows, ABT should protect me from an unexpected economic downturn. As Jim has written, “buy your protection early”.
So I don’t suggest that you buy ABT now or later, or at all. Only you can decide if ABT deserves a place in your portfolio, and if it does, only you can decide when you would like to pull the trigger and buy. My personal strategy is not to try to time bottoms, and to buy when the logic suggesting a significant gain is compelling. Although I’m no expert at “technical analysis”, it appears that technically there is support in the mid-40s.
I am transferring cash into my brokerage account and will be buying ABT next week when my cash is available, provided ABT hasn’t jumped to $50.
USDA…,
Are you suggesting we catch a falling knife (ABT) or that we just watch it fall and wait for signs of new life in 3 to 6 months?
USDAportfolio,
Thanks for the advice and the recommendations for dividend stocks. I’ll look into ABT and T. I think ABT, in particular, has good growth prospects as well.
As my comment on Jim’s Nov 1st post implies, I suspect that Paul McCulley is correct.
https://jubakpicks.com/2010/11/01/even-before-the-fed-acts-the-long-bond-is-signalling-rising-inflation-worries/#comments
There may be some last spasms of life in the dying bond bull over the next month or two, but my recommendation and personal strategy is to avoid bonds (especially, long-term bonds) and focus on undervalued equities with good dividends. They will be a beneficiary of rising rates. To profit, you want to buy them before the trickle of money from bonds becomes a flood.
The recent pull-back has given a good entry-point for companies with solid dividends. One name is ABT, which has pulled back below $47.50. DD and T have also pulled back, and could present an entry point for those who wish to ride the bond-to-equity trade (though ABT is trading at a larger discount to fair value, by my calculations).
“And those who think that the Fed’s real game is to engineer a stock market rally as a way to get the economy growing again would have turned out not to be cynical but correct.”
This was Greenspan’s motivation and that way of thinking has never left office.
When will people learn politics don’t change because the people with true power don’t get elected.