The Stock Market Bubble Doesn't Care About Bonds
The Weekend Edition is pulled from the daily Stansberry Digest.
The U.S. bond market is flashing red...
Charlie Bilello, chief market strategist at wealth manager Creative Planning, recently looked at Bloomberg U.S. Aggregate Bond Index data going back to 1976.
On social platform X, Bilello shared that the U.S. bond market just fell for 58 months through June 2. That's more than 3.5 times longer than the drawdown between July 1980 and October 1981.
In other words, the U.S. bond market is in its longest bear market in nearly 50 years.
Bilello's data shows the maximum decline during the period was 17.2%. That drawdown is relatively shallow... likely because the index includes various investment-grade, fixed-rate bonds. It contains Treasurys, corporate bonds, mortgage-backed securities, asset-backed securities, and collateralized mortgage obligations.
But the situation looks more dire if you focus on what are normally considered some of the safest bonds in the world: long-term Treasurys.
The most popular exchange-traded long-term Treasury fund – the iShares 20+ Year Treasury Bond Fund (TLT) – peaked in August 2020. It has fallen as much as 51.8% since. (Lately, it's more than 41% below its August 2020 high.)
Losing half of your money in the world's safest securities seems like something that shouldn't happen. But it did happen... It's still happening... And no one knows how long it will continue.
Stocks Aren't Fazed by This Bond Bear Market
What's weird is, the stock market doesn't seem to mind...
Bonds are supposed to be safer and less volatile than stocks. When the safer instrument is in big trouble, you'd think folks would worry even more about the less-safe ones.
One of the first things you learn about a company's financials is that equity takes the lowest priority in the capital structure. I explained this many years ago in the August 2007 issue of Extreme Value...
I listed the capital structure from the most senior claim on corporate assets to the most junior claim:
- Secured creditors get paid when the pledged property is sold or refinanced, then
- Unpaid wages, then
- Taxes, then
- Trade creditors, then
- Unsecured debt holders, then
- Subordinated unsecured debt holders, then
- Preferred stockholders, and finally, after all these other claims are met,
- Common stockholders get whatever is left.
Most of the time, this hierarchy doesn't seem too important. The details of capital structure are little more than an accounting technicality to most investors...
Lots of great businesses have plenty of debt, which they service with no problem, because they gush so much cash profit.
Many more companies have lots of debt and little or no profit, but they've raised billions in cash and probably won't run into a financial problem for many years.
But when a company goes bankrupt, the capital structure becomes the word of God. If you're a secured creditor, you'll likely get your whole investment back. If you're an equity holder, odds are you'll get nothing... which could be catastrophic.
The idea carries into the overall market. All those bonds in the Bloomberg U.S. Aggregate Bond Index are senior to all the equity in the S&P 500 Index.
With bonds in a deep bear market, you'd think the stock market would be down 20% or more.
Instead, the S&P 500 is close to making a new all-time high.
So it's not just that stock investors aren't worried... they're over the moon with optimism. They've pushed the S&P 500 into mega-bubble territory, at a cyclically adjusted price-to-earnings ("CAPE") ratio of 36.94.
The stock market doesn't seem to care what's happening in the bond market. It's as if capital structure doesn't exist.
Investors deeply believe in mega-cap, cash-gushing businesses...
These are mostly the familiar tech names like Apple (AAPL), Alphabet (GOOGL), Amazon (AMZN), Meta Platforms (META), Microsoft (MSFT), and Nvidia (NVDA). They're all in the top 10 of S&P 500 stocks, which currently make up about 36% of the index by market cap.
So if you're buying an S&P 500 fund in your 401(k), more than one-third of your investment goes into these companies. Remember, the S&P 500 is the index that's trading at a CAPE ratio of nearly 37.
Investors believe that, like U.S. Treasurys, mega-cap stocks just can't lose over the long term.
But both of those beliefs are wrong. Using a more accurate inflation rate (instead of the deeply flawed consumer price index), you're losing purchasing power at 3% or more per year if you own a 10-year Treasury bond.
Likewise, getting a decent return out of U.S. stocks – especially the tech giants – is harder than most investors realize. Those stocks were cheap a decade ago. Apple traded at 15 times earnings then. Microsoft traded at 17 times earnings. Now, Apple trades at 28 times earnings, and Microsoft at 37 times.
Even nontech, high-quality businesses are super expensive today. Costco Wholesale (COST) traded at 27 times earnings a decade ago, compared with 57 times earnings today.
No matter how great these companies are – and they are among the greatest ever built – buying them at exorbitant valuations when their enormous size limits their growth is not an attractive proposition.
If the S&P 500 reverts to its long-term mean CAPE ratio of 17.2, investors who heavily invest in stocks today could see their retirement fund cut in half.
Invest Outside of the U.S. Stock Market
Alternatives like gold, silver, and other metals can help you reduce the damage...
Having plenty of cash around, even though inflation won't treat it well, can also help you weather a bear market (most of which don't last more than a year or two).
Good corporate bonds at attractive yields can provide you with equity-like returns with less risk. But you have to do the work to find the right ones (like what Mike DiBiase does in his Stansberry's Credit Opportunities advisory each month).
Or you could turn your focus away from the most popular U.S. mega-caps and look into other types of stocks...
For example, commodity-related stocks have often done well during broader U.S. equity bear markets.
Foreign markets like Japan and Europe also have a lot of high-quality businesses that are much more attractively priced than their U.S. counterparts.
The point is, you need to prepare for what could happen if the stock market gets wind of the bond market's fear.
A final word...
I urge you to keep the following famous quote from Ernest Hemingway's classic novel The Sun Also Rises in mind.
When one character asks another how he went bankrupt, he replies:
Two ways... Gradually, then suddenly.
Markets tend to feel like that, too. A bear market can seem to play out gradually as you watch your wealth decline 5%, 10%, 15%... Then, before you know it, your wealth has suddenly been cut by 40% or 50%.
The U.S. stock market has gradually become the largest and most highly valued in the world, for which many believe there is no alternative. But don't fall into the trap of believing it can't suddenly crash.
Look ahead. Understand the state of things right now... and take appropriate action to preserve and grow your retirement wealth.
Good investing,
Dan Ferris
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