Wednesday, August 26, 2020

Deflation or Inflation?

 Second Wave

Bear Market!

Stocks could fall 

30 to 40 percent 

from its recent highs

A. Gary Shilling
August 20, 2020

There is no shortage of investors shrugging off the latest leg lower in U.S. Treasury bond yields, saying heavy central bank involvement in this part of the financial market make such moves less of a signal that the economy or that equities are headed for trouble. That interpretation would be a mistake.

Recall that yields on 30-year government bonds started to decline on Jan. 2, anticipating the fallout from the budding coronavirus crisis that had taken hold in China. Yields fell from 2.34% on that day to 0.94% on March 9, as the price of the benchmark 30-year bond leaped 29%. Only on Feb. 19—seven weeks later—did the S&P 500 Index begin its 35% slide. Fast forward and 30-year yields have fallen from 1.66% on June 8 to a recent 1.19% as their prices climbed 9%. The question is whether stocks will follow again, and with a similar lag of about seven weeks.

DYI:  Since Gary Shilling penned this article the fast moving 30 year Treasury bond has moved back up in yield as of yesterday 8/25/2020 at 1.417%.  For a 30 year bond this remains quite low however as a timing tool for the market so far it appears our second wave market decline may have been postponed until the yield drops for our bell weather bond. 

The recent Treasury bond rally fits with our forecast that the recession has a second, more serious leg that will extend well into 2021, despite massive monetary and fiscal stimulus. Declining business activity saps private credit demand and makes Treasuries shine as havens. A deep recession also breeds deflation to the benefit of Treasuries. The government said Thursday that its core personal consumption expenditure index, which is what the Federal Reserve uses to track inflation, fell 1.1% in the second quarter.

Over the entire post-World War II era, the correlation between Treasury bond yields and inflation as measured by the Consumer Price Index is 60%. This is remarkably strong considering all the other possible influences on long-term interest rates such as federal budget deficits, wars, consumer sentiment and spending, and government actions. My forecast of Treasury bond yields starts and ends with my projection of inflation.

The spread between 10-year Treasury Inflation-Protected Security yields and conventional 10-year Treasury yields, which is what bond traders expect inflation to average over the life of the securities, recently dropped to a miniscule 0.50% from 2.5% in 2012.

Treasury bond investors concentrate on inflation, Fed policy and not much else. In contrast, equity mavens worry about a whole host of often conflicting issues such as corporate finances, profits, price-to-earnings ratios, to name just a few.

DYI:  When the crowd believes in only one direction – hyper inflation – it’s a good bet they will be wrong – deflationary slam.  With valuations for stocks, corporate bonds, high yield and especially junk the markets are ripe for a significant tumble.  How much longer will Wall Street remain disconnected from Main Street is to be debated.  Obviously both of these markets will reconnect either by a robust economy thus reducing sky high valuations or a dismal recession laden economy pushing corporate valuation for stocks and bonds ever higher making a crash the only outcome.

What we do know

Going to Money Chimp using their forward estimated average annual return for stocks this return for an investor purchasing stocks now or holding stocks – [such as S&P 500 index fund] – going to sleep like Rip Van Winkle waking 10 years from now his estimated return will be – drum roll please – a whopping breath taking negative -0.24%!  This return is nominal – [before expenses] – as most 401k’s charge a 1.0% management fee, trading impact costs for those with a managed stock fund of 0.50% AND of the ever present inflation if we don’t experience deflation if so it will be the only bright spot delivering increased purchasing power. 

So…Adding it all up with 1% management fee, 0.50 trading impact costs, and standard inflation rate at 2.0% that comes to a negative drag of -3.5% added on to our negative -0.24%.  For a ten year hold negative average annual return of negative -3.74%!

Bottom Line

Unless you are a successful speculator who can move in and out of markets without taking a serous loss for us mere mortal long term valuation driven investors know this is a terrible time to invest in stocks and bonds.  Valuations are way above their historical norms making long term investing on par with a trip to Las Vegas.  Here at DYI all is not lost whether deflation or inflation precious metals and their respective mining company shares will win the day along with a mighty cash horde!

 Updated Monthly

AGGRESSIVE PORTFOLIO - ACTIVE ALLOCATION - 8/1/20

Active Allocation Bands (excluding cash) 0% to 50%
65% - Cash -Short Term Bond Index - VBIRX
35% -Gold- Global Capital Cycles Fund - VGPMX **
 0% -Lt. Bonds- Long Term Bond Index - VBLTX
 0% -Stocks- Total Stock Market Index - VTSAX
[See Disclaimer]
** Vanguard's Global Capital Cycles Fund maintains 25%+ in precious metal equities the remainder are domestic or international companies they believe will perform well during times of world wide stress or economic declines.  

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DYI

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