Bonds Have Been Terrible. That Should Change. And Updates On Momentum & Inflation

In the last couple of weeks, the yield on the 10-year Treasury Note has reached 5%, the highest level in 20 years. With stocks priced at historically high valuation levels, most areas of the bond market are offering competitive alternatives for the first time in a decade. More on that inside.

We’ll also touch on momentum investing and inflation trends. And of course, don’t forget the humor.

The 10-year Treasury Note Yields 5%.  That Might Beat Stocks

From February 27 this year to September 28, the yield on the 10-year Treasury Note has increased from 3.96% to 5.24%, a 128 basis point increase in just over six months.  Bond funds of shorter duration have managed to eke out reasonable returns in this period, but not those with longer durations.  See the table below showing various asset classes.

As the chart below shows, courtesy of www.stockcharts.com, one would have to go back to 2006 and 2007 to find yields at these levels.  From 2018 to 2020, yields plunged from the 3.25% level to about 0.50%, the latter drop associated with the Covid recession and the Fed cutting rates aggressively.  However, starting in 2022, the Fed finally reversed course and took the Fed Funds rate from essentially 0 to near 5.50%, before they started cutting rates again in September 2024, ultimately reducing the Fed Funds rate by 1.75% by December of 2025 until their first hike on September 16.  Note that changes in the Fed Funds rate don’t necessarily correlate with what the 10-year Treasury Yield does.  They have significantly different durations.  

Whether it is rates falling or rising, the duration of bonds determines how sensitively prices respond.  Shorter duration bonds and bond funds have much more muted responses to big changes, while longer durations display much more elevated price increases and decreases.  This is evident in the table above.  

On a longer term basis, we went back 10 years to 2016 to show just how different (or should I say, crappy?) bond returns have been during this period.  From July 31, 2016 to July 31, 2026, the yield on the 10-year Treasury Note increased from 1.46% to 4.74%, an increase of over 325 basis points (3.25%).

It is easy to look back and ask oneself, why the heck have I owned bonds for the last 10 years?  But that defeats the purpose of diversification, and it also assumes you would have known the future.  The former is important and the latter is impossible.  Unlike with stocks, where there are many different valuation methods to project future returns, perhaps the most reliable method of forecasting future bond returns is the starting yield.

Ten years ago, the yield on the 10-year Treasury was 1.46%, and the approximate duration of the Vanguard Total Bond Fund is currently 5.73 years.  Its 1.2% compound return the past 10 years closely mirrors the starting yield.  For perspective related to the top table, the duration of PULS is 0.33 years, and that of IBDS is 0.73, which explains why they have been able to post positive returns for the past 7 months in a rising interest rate environment.  In contrast, the duration of BHYIX is 2.97 and that of TLT is 15.01, which is why it has suffered the most.  

From a portfolio management perspective, we’re not comfortable owning long-duration bonds or ETFs.  With great timing, you can hit home runs in bonds.  You can also get your rear handed to you.  We don’t view bonds/fixed income in that manner.  We want that portion of a portfolio to be more of the mostly predictable part, though many outsiders might question our long-term devotion to the high yield bond sector, an area we have been trading in since the late 1980s.  

For many years, a 100% allocation of our fixed income to high yield was the norm, because of the robustness of our risk management model.  Why not?  Over long periods of time, high yield bonds have produced the best return of any bond asset class, but once in a blue moon, they have some pretty substantial drawdowns.  That’s why we use a risk management model.  Today, close to 50% of our fixed income allocations are still in high yield, and at some point, we’ll likely increase that to the 65-75% zone, but not until credit spreads blow out to the upside, and nominal yields are much more attractive than they are today.

Going back to the concept of the starting yield, with the 10-year Note at 5.24%, that is what one could likely expect to earn on a gross basis for the next 10 years, which compares quite favorably to capital market assumptions from Vanguard on the expected annual returns from U.S. equities looking out 10 years, which are in the 4%-6% range.  Granted, models of those types have underestimated stock returns for the past 5 to 10 years, but that doesn’t mean one should throw them out.  In fact, it likely means at some point, actual returns are going to come in lower than the projections (what is called mean reversion).  

Look at the chart below, courtesy of our friends at The Leuthold Group.

This concept takes the price/earnings ratio of the S&P 500 and normalizes it over the past five years.  The more popular method of normalizing earnings uses Robert Shiller’s CAPE ratio (cyclically-adjusted PE), which normalizes earnings over 10 years.  The latter method is currently projecting 10-year compound returns of about -1% per annum, while the 5-year method is projecting returns of 1% per annum.  

This may seem implausible to many investors today, that stock returns could go nowhere for 10 years, but the reality is, measures such as these have only been more expensive once in history, during the 1999-2000 time period.  The last time the 5-year normalized PE reached current levels of about 33 was in 2021, prefacing the bear market of 2022.  

Before this sounds too negative, let me remind you (and myself) of the following.  I really have no idea how things will play out going forward, and no one else does either.  This is why we use models rather than emotions or feelings.  All I know is this—with all things considered, 5% plus gross yields in the 2-year to 10-year range look nicely compelling at this point.  

If You Think You Know, This Is A Reminder That You Don’t

If I would have told you in January that in the next 8 months, interest rates on intermediate bonds would rise over 100 basis points, the inflation rate would increase from 2.4% to 3.4%, and oil prices would surge from about $60 per barrel to over $100, you and many other investors would probably conclude that stock prices would suffer accordingly.  All of the above did come true, but instead, as I write this, the S&P 500 Index has gained nearly 14% for the year.

Often, relationships we think would have a positive or negative effect on the stock market don’t hold up to further examination.  This is a good time to remind investors of this, especially as we approach the mid-term elections in November.  There’s always something to worry about, but in practice, it’s not a good idea to be making portfolio decisions based on your political leanings, worries, or even fear about what AI (artificial intelligence) is going to do.  Personally, I think we’re in an AI bubble, and some day, it’s all going to unwind.  But, I have no idea when or how.  Meanwhile, we just follow our models, and good old MO (Momentum).

Good Ole MO

Since getting involved with technical and quantitative analysis in the mid-1980s and being exposed to dozens of different indicators and models, I’ve found that there are only a few things that have stood the test of time.  For me, that is trend-following and relative strength, or momentum investing.  The latter is at the core of our investment selection process for equity fund and individual stock selection.  

With the help of research providers Ned Davis Research and Dorsey Wright & Associates, we’ve been able to quantify approaches to these areas, allowing us to implement the research in real-time, based on historical results.  Our interest in relative strength was initially piqued during the 1990s upon the publication of a seminal book titled “What Works On Wall Street,” by James O’Shaughnessy in 1996.

In the book, O’Shaughnessy tested dozens of indicators for stock selection, taking the Compustat database back to 1963, looking at 33 years of data in most cases, and in some cases going back 90 years. At that time, he found that one of, if not the most robust indicator of them all was relative strength, which is defined as the tendency of investments to exhibit persistence in their relative performance.

I’m not going to delve into formulas here, as there are many variations, but in general, momentum investing can be described as follows.  Buy what’s going up, and when it stops going up, sell it.  I like the fact that it’s simple, and can be articulated to almost anyone, whether or not they have finance experience, but most of all, I like it because it works!  Not every year, of course, but over time.  

With the advent of computing power and the proliferation of ETFs during the past 15 years or so, along with the elimination of trading commissions, being able to replicate studies in real-time is much more feasible than in the past.  We have been running a strategy of individual stocks within the S&P 500 universe since early 2020 using principles of relative strength, and its more than six-year track record in real time has validated our hopes, which is to beat the S&P 500 Index, something that is really hard to do.

Last December, we inserted into all tactical portfolios an ETF that follows a similar approach, the S&P 500 Momentum Index (symbol SPMO).  Its 10-year chart is shown below, courtesy of www.stockcharts.com.

For the past 10 years, the performance of the ETF within its peer group of the large blend category with Morningstar has been in the top 1% for the past 3, 5 and 10 years, and also year-to-date, with a gain of just under 29%, doubling the S&P 500.  Needless to say, it has been working pretty well, but no doubt it will at some point go through a period where it sucks.  That’s when you need to stick with it.  No model keeps going without a period of underperformance.

Witness after June 30 of this year, when the fund was up about 40% for the year.  I thought to myself, “there is no way this can go on.”  Sure enough, in July, the index had its second worst month in around 40 years.  

In our individual stock strategy, I’ve been dollar cost averaging and adding capital every month to my personal account, fully knowing that at some point, we’re going to have another 2022 or worse.  When stocks are down -25% to -35% or more from their peak, which doesn’t happen often, that’s when you really want to add to a strategy that is as robust as momentum.  

Inflation Trends

In conversations with friends, clients and family, it seems everyone comments on how expensive everything is, from food, to homeowners insurance, to gas prices, and airline tickets to name just a few items.  And the evidence is real.  See the chart below, courtesy of Creative Planning@CharlieBilello.

If you’ve been keeping up with Federal Reserve policy during the last several years, have you ever wondered what their Board is smoking?  An inflation target of 2%.  Did you know that we’ve had 66 consecutive months with year-over-year inflation greater than 2%?  We haven’t had 2% inflation in over 25 years.  Take a look below at some specific categories.

From Starbucks to steaks, you’re looking at 50% plus increases, and I can tell you that the bumps in family medical insurance seem quite low, as at TABR, we’ve endured annual increases in medical insurance of 8%-11% annually for the past five years.  Have you been on a plane recently?  I fly usually about once per month, and I can attest airline tickets have gone through the roof, thanks to the war in Iran and subsequent increases in jet fuel.  It’s nearly $700 round trip right now just to fly from Ontario to Sacramento.  Yep.  But don’t blame the airlines.  American Airlines noted in a recent article that fuel will add $1 billion in extra costs in the last three months of the year alone.

This is not a political statement, but ultimately I think this one factor (meaning inflation, or the cost of living) is going to swing the elections in November, with a possible Democratic sweep.  At present, the odds from prediction market site Polymarket have a 96% probability of Democrats winning the House of Representatives, and a 64% chance of also taking the Senate.  

The stock market in the long run is the best asset to stay ahead of inflation, and it historically does not run into trouble until annualized inflation starts moving above 4-5%.  We’ll see.  Stocks have been defying the odds of a weak mid-term election year, thanks to tremendously strong earnings growth.  At some point, that will stop.  Nobody knows when, though.  But, it will show up in market action.

TABR Portfolio Allocations

At present, three of our five stock market risk models are in positive mode, dictating 60% exposure within our tactical accounts for stock allocations.  The configuration is such, though, that a bad week coming up could flip two more models negative, taking us down to 20%.  We’ll just have to see.  Adding some concern to that is that our high yield bond risk model just flipped negative for the first time since April 17.  

The last SELL signal in the spring did not work out, with us having to buy back higher.  That is the risk of trend following.  But, I can say this.  High yield bonds have tended to be a leading indicator of the stock market.  Though not every SELL has resulted in a significant decline in stocks, other than the Covid meltdown, virtually every other significant decline in stocks for the past 25 years has been preceded by a SELL in high yield bonds.  We’ll be moving the high yield capital to the relative safety of ultra-short term bond funds and then awaiting further market action in coming weeks.

Material Of A Less Serious Nature

Two statues were standing in the park, one a naked man and one, a naked woman.  They had been staring at each other across a pathway for 100 years.  One day, an angel comes down from the sky and with a single gesture, brings the two to life. 

The angel tells them, “As a reward for being so patient through 100 blazing summers and dismal winters, you have been given life for 30 minutes, to do what you wished to do the most.”

He looks at her.  She looks at him.  They go running behind the shrubbery.  The angel waits patiently as the bushes rustle and giggling ensues.  After 15 minutes, the two return, out of breath and laughing.  The angel looks at his watch.  “Um, you have 15 minutes left. . .would you care to do it again?”

He asks her, “Shall we?”  She eagerly replies, “Oh, Yes, let’s!  But we should change positions.  This time I’ll hold the pigeon down, and you $hit on its head!”

If I don’t mind saying so, that’s hilarious!  What’s not so funny are all the terrible injuries in the NFL after only two weeks into the season.  What a brutal sport.  My Niners are 2-0 but already have 16 guys on injured reserve.  Geez.  There must be an electrical substation near Oracle Park in SF, where my SF Giants used 71 players this major league season, I believe the most in history.  If there’s a God, please don’t let the Dodgers win the World Series again!

Meanwhile, as always, thank you for the trust and confidence you place in all of us at TABR.  We can’t do what we do without you.

Sincerely,

Bob Kargenian, CMT

President

TABR Capital Management

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