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Doug Behnfield’s ‘Thoughts on the News’

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[Over the years, we’ve featured the investment ideas of our friend Doug Behnfield often enough that longtime readers will understand why we consider him the smartest guy we know. The Boulder-based financial advisor’s most recent letter to clients, dated July 6, is of particular interest and is reprinted below with his kind permission. It suggests that it is time for investors who have accumulated steady gains in long-term bonds since inflation peaked in 1981 to begin thinking about alternatives, particularly stocks that would look quite attractive if they were to fall hard in a bear market. Indeed, rates on  10- and 30-year Treasurys have fallen to lows, respectively, of 1.33% and 2.10% that don’t leave much room for more downside.  While we agree with Doug’s cautionary stance, we believe nonetheless that yields will fall even lower before they turn. How much lower?  Our technically-based target for the 30-Year T-Bond, currently yielding 2.23%,  is 1.64%, with an outside chance of 0.62%(!). Our forecast for the 10-Year T-Note, currently at 1.51%, calls for a commensurate drop to lows approaching zero. If this should come about, those who hold government debt maturing well out the yield curve stand to reap very substantial capital gains, since bond prices, which vary inversely with yields, are highly leveraged to small fluctuations in long-term rates . RA]


“It’s the market that makes the news, not the news that makes the market”

-Bob Farrell, circa 1987

Brexit may not be the reason for all the market action we have experienced in the last few weeks. After all, 72% of eligible voters in Great Britain went to the polls and 49% voted “Leave” while 47% voted “Remain”. How British. At the Coliseum, it would have been “Thumbs up” or “Thumbs down”. It was basically a split decision. Older, middle-class citizens showed up and voted “Leave” while the Elite and the younger voters, (along with the Scots and Northern Irish) showed up less and voted “Remain”. There is nothing new here but there is certainly news. And for those of us struggling to make appropriate investment decisions, an understanding of how the financial press works is an essential part of good investment strategy, offering a great window into investor sentiment.

In the words of George Friedman, respected founder of Stratfor and a leading geopolitical analyst:

“The reporters of leading British media were talking to their European and American counterparts. The politicians were doing the same. And the financial community is on the phone daily with colleagues around the world. The challenge that was posed in the U.K. referendum is present in many countries around the world, albeit in different forms. What has become universal is the dismissive attitudes of the elite to their challengers. It is difficult for the elite to take seriously that the less educated, the less sophisticated and the less successful would take control of the situation. The French Bourbons and the Russian Romanovs had similar contempt for the crowds in the streets. They dismissed their lack of understanding and inability to act – right to the moment they burst into the palaces…In the end, the financial decline on Friday [611 Dow Points on 6/24/2016] resulted from the lack of imagination of the elite. And it is that lack of imagination that led them to believe that the current situation could continue. That lack of imagination, the fact that the elite had no idea of what was happening beyond their circle of acquaintances, is a far greater crisis in the West than whether Britain is in the EU or even if the EU survives. We are living in a social divide so deep that serious people of good will and a certain class have never met anyone who wants to leave the EU or who supports blocking Muslim immigration or perhaps even who will vote for Donald Trump.”  (1)

The facts surrounding the European Union are fairly well understood. They are going through a broad and significant degree of dysfunction. All this vote did was allow (or perhaps force) the financial press to reveal the cracks that have been there for several years. Still, it was a virtual tie and the actual separating of Great Britain from the European Community probably cannot happen very soon. George goes on to describe the geopolitical revolution that is taking place in Europe:

 “The European Union has been caught in long-term stagnation. Eight years after the financial crisis it is still unable to break out of it. In addition, a large swath of Europe, especially in the south, is in depression with extremely high unemployment numbers. An argument could be made that these problems will be solved in the long run and that Britain should be part of the solution for its own sake. The counterargument is that if the problems had been soluble they would have been solved years ago.” (1)

Complacency Masks Facts

And so, the essence of Bob Farrell’s quote is that the underlying facts are already out there, but often disguised by complacency (near tops) and despair (near bottoms). It is the action of the various markets (particularly the stock market) that makes those facts impossible to ignore.

John Kenneth Galbraith elegantly described how the market snaps us out of our complacency in an elegant way in The Speculative Episode when he described how bear markets begin:

“When it comes, it bears the grim face of disaster. That is because both of the groups of participants in the speculative situation are programmed for sudden efforts at escape.  Something — it matters little-although it will always be much debated triggers the ultimate reversal.  Those who had been riding the upward wave decided now is the time to get out.  Those who thought the increase would be forever find their illusion destroyed abruptly, and they, also, respond to the newly revealed reality by selling or trying to sell.  Thus the collapse. And thus the rule, supported by the experience of centuries: the speculative episode always ends not with a whimper but with a bang.”  (2)

The current problems facing the global economy and the deflationary forces impacting the financial markets have become increasingly clear over the last couple of years. But by definition, complacency reaches its maximum near the top of the market. Up until very recently, we seemed to be reeking of it, particularly with regard for downside risk in the equity market, recession risks and geopolitical risks and exorbitant debt levels among all categories of borrowers. The primary factors enabling the general complacency are market related because equity values are hovering near the highs. There has also been, quite typically, a persistent expression of hope on the part of investment professionals and the financial press that an economic recovery will bail us out before the business cycle heads south, even as the stock market has long since lost its upward momentum. Conversely, at market bottoms, fear and caution are palpable and hope is in short supply.

S&P 500 Monthly (R1)

Just last week, the S&P 500 (SPX) traded within 1% of the all-time high reached in May, 2015. The Dow Jones Industrial Average (DJIA) got within 2% of its all-time high. [Note: Since this report was published three weeks ago, both averages have climbed to record highs. RA]  But the broad market, represented by the New York Stock Exchange Index (NYA), has been a meat-grinder since mid-2014 and currently sits 6% lower than it was 2 years ago (See chart, next page).

NYSE Index (R2)The negative price performance of the broad stock market and the generally uninspiring performance of intermediate term investment-grade fixed income securities has resulted in the return for the average investor being dismal over the last couple of years, but not without several bouts of dramatic volatility. A garden-variety 60% stock/40% bond Moderate Portfolio Allocation has delivered a cumulative total return for the last 2 years of less than 5% before fees. (3)

54% Return on ‘Strips’

In the meantime, the total return on extremely long duration Treasury and Municipal bonds has been very high by historical standards. In the last 2 years, the cumulative total return for the November 2043 Treasury Strip was 54%. (4) During the same period, the UBS Universe of leveraged, tax-exempt closed-end municipal bond funds gained 30%. (5)  In an example of the longest duration bonds in our client portfolios, the AA rated San Diego School District 0% coupon General Obligation municipal bond due in July, 2049 was up 113%! (6)

Long-term bonds in other developed countries have also experienced strong performance (in local currency terms) as interest rates globally have continued to decline substantially.

The message of the bond market has been one of very weak economic growth and low inflation (bordering on recession). On the other hand, the message of popular stock market indices is being interpreted as reflecting an economy that is experiencing a mere pause. A rule of thumb on Wall Street is; if the stock and bond markets are telling different stories, believe the bond market.

DJIA-30 Yr yield (R3)Our toughest decision when faced with persistently strong performance in the bond market (not only for the last 2 years but for the last 35 years) is when to sell. Here are some things to take into consideration:

Bonds Outperformed Stocks

While most pundits focus on the risk of losing principal if rates rise, the biggest risk for the fixed income investor for the last 35 years was loss of cash flow as rates declined relentlessly. When the yield on bonds is 6%, your $1 million bond portfolio generates $60,000 per year in income. With a decline in rates to 3% your portfolio would need to double to $2 million to generate the same cash flow. And that is precisely what happened in the longest duration government bonds. As a result of pursuing the conservative goal of earning a stable income while preserving capital, the long Treasury bond has outperformed the broad stock market (and with a fraction of the volatility) over the last 15 years.

Interest rates have declined steeply during every bear market in stocks that I have witnessed in 39 years as a Financial Advisor. That is because bear markets exert enormous deflationary pressures on the economy. We are overdue for a bear market. The last 5 years where stocks have advanced even as rates have been cut in half have been a very fortunate, if unusual turn of events. Going forward, you have to ask; “who do you want to believe-the stock market or the bond market?”

Finally, there is the issue of where to put the money. It will be very challenging to continue to achieve the goal of preserving capital while generating adequate cash flow if we dramatically reduce our exposure to the bond market. That is another way that the stock market can play a big part in our investment strategy in the future.

Today, the S&P500 pays $45 in dividends. At the current index level of 2100, that equates to a dividend yield of 2.14%. If the S&P 500 declined to 900, the dividend yield would be 5%. A decline of that magnitude is by no means out of the question (nor a prediction). But keep Bob Farrell’s Market Rules to Remember in mind when looking at that long-term chart. Coincidentally, a decline from 2100 to 900 is a bit over 57%, which is practically identical in percentage terms to the 2007-2009 bear market. Recall that the yield on the index represents an average of 500 separate blue-chip companies. With today’s yield of 2.14% Google pays no dividend and AT&T pays 4.4%. There would be some companies that pay no dividends at all and some very high quality and conservative companies that would pay 6% or more if the index declined enough to raise the yield to 5%.

Market Crash: The Upside

It makes perfect sense that the next bear market, particularly if it is accompanied by a recession, would take the interest rate on bonds down to a level that would finally make them unattractive. At the same time, another gut-wrenching decline in stocks would produce the kind of valuation and investor sentiment that would make high quality/high yielding stocks a safer and more appropriate way to achieve the goal of preservation of capital accompanied by adequate current income.

Back at the stock market lows in early 2009 such circumstances did not exist. The dividend on the S&P500 was $25 so the yield only hit 3.75%. Closed-end municipal bonds funds still offered yields exceeding 7%, while selling at steep discounts to their underlying Net Asset Values. This time around, I am anticipating much lower yields on muni funds and the likelihood of substantial premiums. Thirty year Treasury bond yields could drop well below 2%.

Our current allocation would benefit tremendously from such an outcome, but I am focused on the necessity of not being dogmatic in the face of our successful strategy in recent years. In the meantime, it seems likely that the decline in interest rates that has powered our investment performance will persist for the next 18 to 24 months that constitutes our investment strategy horizon.  Nevertheless, we are still on high alert now that yields have broken down to new, all-time low levels.  After all, our primary focus is to sell on strength, rather than to get out with our tail between our legs.


1) The Surprise at Brexit and the Social Crisis Behind It, George Friedman; 2) A Short History of Financial Euphoria, John Kenneth Galbraith; 3) UBS PMR Benchmark, Moderate Blend ; 4) Sangeeta Marfatia, UBS Closed-End Fund Research; 5) J.J. Kenney; 6) Thompson One

Please do not ask trading questions!

  • John Jay July 31, 2016, 8:02 pm

    Well, Rick, I think the more the rest of the worlds’ bonds pay ZIRP or NIRP, the more global money managers will chase yield in US Treasury paper. That sure makes the Feds’ job a whole lot easier, they can use that fact as an “Autopilot” to keep the interest the Government has to pay on their ever increasing debt at next to nothing!
    Sweet deal for them!

    And with three months left until our election, the market will probably spike and drop as the Trump/Clinton battle plays out.

    Right now I am amazed Trump fell for that obvious set up with the guy and his wife whose son was killed in his MENA deployment.
    Did he think that guy just walked up to the microphone off the street, and was allowed to deploy that propaganda IED by accident?
    Even I could see the baited trap set out for Trump!
    All he had to say to defuse the IED was “I understand the families grief, so I will respectfully remain silent on this matter”
    This was his worst gaffe yet, I hope he shuts up and lets it fade away.

    Because 4 years of Hillary means Obama gets confirmed by our amazing Senate as a Supreme Court Justice.
    Four years of Hillary makes us Brazil
    Eight years of Hillary makes us Venezuela
    I kid you not, as Captain Queeg often said!

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