Stocks are expected to return to last year's lows due to the decline in long-term bond prices and record high, long-term interest rates.
Our new investment allocation is 50% stocks, 10% GLD, 25% Zero Coupon Treasury Bonds, and 15% cash.
The indicator of the Hulbert survey of newsletter writers suggests a rally in treasury bonds, which is an important factor behind our dynamic asset allocation.
Our dynamic asset allocation is essentially - bonds first, then stocks. The key element is the timing of the change back to a more aggressive stock allocation.
On October 2nd we wrote an article titled the Warren Buffett Bear Market explaining why we thought stocks are headed back down to last year’s lows. In the article we said this:
"Why Stocks Will Follow Bonds Lower
This five-year chart diagrams the price changes of the S&P 500 against the price changes of a 20-year treasury bond as represented by iShares ETF TLT . It shows what we expect the stock market to do, and why.
The green arrow shows that we expect the stock market to return to the lows of last October, and the black Oval highlights the reason why - that long-term bond prices are hitting new lows because long-term rates are hitting new highs.
The stock market can ignore bond prices for a while but sooner or later the bond nature of stocks must show itself and the two act together. It's our opinion we're at that "show and tell" moment now."
Comparing Stock Prices to Bond Prices (The Sentiment King)
Asset Allocation Change
To implement this new view, we made asset allocation changes last week. The allocation is based on a sequence of events we've noticed numerous times concerning interest rates and declining stock prices but never had the opportunity to act on.
The sequence is this: A bull market continues to advance while long term interest rates rise (bond prices fall). Near the peak in rates, stock prices reverse, and a bear market begins. As stock prices fall, interest rates begin to decline (bond prices rise) reaching their lows as stock prices reach their lows. The sequence is simple - first bonds, then stocks.
Based on this sequence, the following is our current investment allocation:
We made the change not only because we believe stocks have already started the movement back to last year’s lows, but also because an important indicator (to us) points to an imminent decline in long term rates and a rally in treasury bonds. In other words, the investment sequence described above is already in play.
This is an active and not a passive strategy. If we're right, we'll hold the above allocation for six to nine months. If all goes well, we'll take profits in bonds and reallocate the proceeds back to stocks near their lows, changing the allocation back to a more aggressive stance of 75% stocks.
We believe the Vanguard zero coupon treasury ETF ((EDV)) is the best fund to use to implement the bond side of this strategy, since it will produce the greatest profit if long term rates fall, even if just a little.
When long term interest rates were over 10% in the 1980's, we used zero coupon "strips" to create guaranteed retirement income and to hedge against the risk of falling rates. They are a wonderful vehicle to achieve large price gains from bonds when purchased at the right moment. Of course this price risk goes both ways when used for that purpose.
The Bond Market Buy Signal and EDV
This is the indicator we’ve found best to forecast interest rates. It's based on the Hulbert survey of newsletter writers who forecast the bond market. You would think it should be based on something more fundamental or economic, but over the years we have found otherwise.
Mark Hulbert has long kept a daily track record of what newsletter writers are saying about bonds. It acts as the contrary opinion indicator and his records go back to before 2000. To gain a longer term perspective, we take his daily numbers and perform a time weighted moving average on them. We then graph the moving average on the Sentiment King red-green ranking scale. A Green Zone reading - which represent when most writers are bearish on bonds - is bullish. The opposite is true for the Red Zone. (The Sentiment King)
Like all investment surveys it acts as a contrary opinion indicator. When too many newsletter writers are bullish on bonds, bond prices usually decline. The opposite is true if they’re bearish.
The chart graphs our ranking of the survey over the last thirteen years against the price of EDV and highlighted key moments with green arrows, including the current one. Green zone readings are when writers are bearish on bonds, which is bullish. Red zone readings are when most are bullish on bonds, which suggests caution.
This indicator, plus the clear, five wave structure of the three year price decline, is strong evidence to us that the bear market in bonds is at least temporarily ending and a strong rally lies ahead.
Why Use EDV?
We are using EDV for our bond asset not because of its income (which is zero) but because of its price volatility and correlation with long-term rates. This next chart highlights the almost perfect correlation between EDV and 30 year bond yields (TYX). They are mirror images of each other as theory says they should be, since the effective maturity of the EDV portfolio is 25 years.
The almost perfect correlation between 30 year T-bond rates and EDV (The Sentiment King)
We believe the indicator in the previous chart, plus the five wave declining structure, suggests that 30 year interest rates will decline to 4%. We've indicated this with a black arrow. If it does, EDV will increase from its current price of $63 to $80, which is a gain of 27%. This is by far the largest potential price gain of any long term treasury bond ETF available, which makes it perfect for our purposes.
We expect this to happen over the next six to nine months, which is why EDV is a primary investment in the new allocation. This, plus the expected 20% gain in GLD, will help offset our expected 15% to 20% decline in stocks.
Risks
As we see it the immediate risk is that the investment sequence is too early - that interest rates will continue to rise and stock prices will continue to fall. Then this period of stocks and bonds declining together would continue. But we don’t think this trend would carry on for very long.
We also don't think it's probable that interest rates will continue to rise and that stock prices will begin to rally. If it did our bond and stock allocations would offset each other.
Basically, we're staying firm to our belief that critical market moments like this are found using indicators of market sentiment, and like last year with the stock market, this is another example of how to apply the theory to real time conditions.
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