You have heard you shouldn’t fight the Fed. Well, one man is saying we shouldn’t fight the bond market either.
That man is Jeffrey Gundlach, head of money management firm DoubleLine Capital and manager of the DoubleLine Total Return Bond Fund (NASDAQ:DBLTX).
Gundlach cringes at the sight of the endless parade into equities on the premise that what the Fed pumps up can’t fall down. According to Gundlach, while the call is correct that whatever the Fed pumps up can’t fall down, what investors are getting wrong is the type of instrument the Fed is actually pumping up—it isn’t stocks.
The man does have an impressive string of accurate contrarian calls, predicting the 2007 subprime mortgage crisis, the rise of Treasuries, Apple’s (NASDAQ:AAPL) fall from $700 to the $400’s, the rise in natural gas, and the recent tumble of the Yen.
What he has to say about stocks and bonds, then, just may be worth listening to.
That “Idiotic” Great Rotation Idea
For some time now, people have been making calls on a “great rotation” out of bonds and into stocks. Their reasoning is that the Fed’s easy money policy greatly assists companies’ operations, driving up profits and in turn driving up their stock values. What is more, the Fed’s bond and treasury purchases keep narrowing bond yields, making stocks even more attractive.
With so much to be won from capital gains on stocks, the idea is that it would be foolish to keep cash tied up in bonds, which earn such dismal returns. Hence the expected rotation in allocation from bonds to stocks.
But Gunlach scoffed at this premise in a Bloomberg interview:
“People keep talking about this idiotic ‘great rotation’ thing, but I think the question of what people are going to do with their money gets harder by the day.”
Gunlach doesn’t question the expectation that what the Fed pumps up will not fall down. What he is questioning is which market the Fed is really pumping up.
“There’s an idea that there is a put on the stock market. You’re saying that when stocks go down or the economy weakens, the Fed will step in,” Gundlach explained to Investment News. “Actually, the put is on the bond market,” he clarified, because when the Fed steps in, it steps in to buy bonds, not stocks.
Since the Fed has not changed its plans to keep buying bonds and mortgages for several more quarters to come, Gundlach sees bond prices well supported with yields ranging from about 1.5% to 2.5% for the remainder of the Fed’s buying spree.
Partially Redirected Flows
The Dow Jones Industrial Average has steadily risen from 12,600 in mid-November to as high as 14,800 earlier this month, a gain of 2,200 points, or 17%, in just 5 months. So it is clear that at least some money is being redirected into stocks.
As the manager of one of the world’s best-performing bond funds, Gundlach himself has seen firsthand a gradual slowing of new money into fixed income as it gets redirected into the red hot stock market.
Acknowledging a slightly lower demand for his own bond fund, Gundlach admits, “Will bond inflows fall? I think the answer is yes.” “If bond yields stay where they are,” he gauges, “we’re getting to a place by the end of July where the 12-month trailing return is just over 1 percent.” “There will be a rethinking of bond allocations,” he predicts.
Which Will Collapse First?
Gundlach sees a real danger in even a partial flight to stocks, considering them “overvalued assets”.
“Right now … most have been negative on Treasury bonds,” he assesses. “They think yields will explode higher because the Fed stops buying.”
But Gundlach is telling everyone not to jump the gun. The Fed is not planning on ending its bond buying anytime soon.
“I don’t expect QE to stop,” he affirms. “It’s a sensible idea, but it’s not timely. Investment success is about timeliness more than anything else.”
What is more, he feels the U.S. housing market may be recovering much too quickly, creating another bubble in real estate prices just a few years after the last one. “Who knows how this new housing bubble will end?” he voices his alarm.
Consequently, the current redirection of money into equities cannot last very long, Gundlach believes, and it will certainly not be enough to kill the bond market.
According to the Investment Company Institute, Q1 of this year has seen some $67 billion of new investments flowing into equity funds, while $72 billion flowed into bond funds, showing that he is not the only one who values the protection of bonds, despite their minuscule yields.
Increasing Debt
Worrying him all the more is the U.S. government’s $120 trillion unfunded liabilities, which include Social Security, Medicare, and other entitlement programs.
“The idea that you will pay that back with today’s valued currency stretches the imagination,” he marvels. “It will take a crisis to get people to notice.” “Now we continue to have debt increasing.” “It’s simply at the point where you can’t pay it back.”
Gundlach shudders at the limited options available in addressing the debt burden. They would have to include a weaker dollar and higher taxes, with inflation trailing not far behind them—all of which are detrimental to the business climate.
He cautions investors to keep their eyes on corporate bond yields. When they start rising, it is a warning that inflation will quickly be upon us. And the flow will once again revert from stocks back into bonds.
Cracks may have already begun appearing in the equities market. Some 75% of U.S. companies reporting Q1 results have underperformed consensus.
What is more, according to the Stock Trader’s Almanac, we are just one week away from the start of the seasonal 6-month equities pull-back from May to October, a time when history shows investors are better off switching out of equities and into safety plays, like Treasuries or bond funds.
Ah, Treasuries and bonds—those unattractive but practical vehicles that you don’t like to drive around in but do anyway because you feel safe in them. They’re what made Gundlach rich.
Joseph Cafariello
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