Global Forex
We evaluate the prospects for bonds, stocks, and real estate. In Part One, we learned that markets are far from rational. Thus, we cannot rely upon the world to ensure prices are fair. In Part Two we examined the macroeconomic forces driving investments.
In this section, we evaluate investments using the science of irrationality, including our understanding of the lizard brain, and the art of macroeconomics.
With these two complementary tools, we turn our attention to the most important financial investments. In Chapter 7, we examine bonds, and ask if interest rates are going to rise substantially. In Chapter 8, we evaluate the stock market. Has the bull market in stocks returned, or is the early twenty-first century stock market rally a trap? In Chapter 9, we evaluate real estate and ask if there is a housing bubble.
In The Meaning of Life, the Monty Python comedians start by asking, "What's it all about?" In answer, the movie provides humorous perspectives on ponderous subjects including birth, conflict, old age, and death, and concludes with:
Well, that's the end of the film. Now, here's the meaning of life. . . . Well, it's nothing very special. Uh, try and be nice to people, avoid eating fat, read a good book every now and then, get some walking in, and try and live together in peace and harmony with people of all creeds and nations.
After a tumultuous film, "be nice to people" might seem a bit obvious. Similarly, the "sell long-term bonds" advice in this section might appear modest. After brain scans, chimpanzee productivity, and seashell arbitrage, can't the new science of irrationality say more? Absolutely. The final two chapters of this book provide novel and surprising advice on how to outsmart the lizard brain. This innovative "logic of the lizard" approach builds on the clear evaluations of bonds, stocks, and houses of this section.
BONDS Are They Only for Wimps?
U.S. History Has Favored the Bold
"Bonds are for wimps!" So declared Harvard Professor Greg Mankiw in 1993 when I was a Ph.D. student in his macroeconomics class. Professor Mankiw is not only a world-class researcher, but also a great communicator. I found him to be an excellent teacher, and his ability to make economics interesting has allowed him to write several best-selling textbooks.
When Professor Mankiw said, "Bonds are for wimps," I don't think he was making an investment recommendation. Rather he was being a great teacher by using colorful phrasing instead of using the technical term "the equity premium puzzle." 1
The academic research on the equity premium puzzle examines the money that has been made in U.S. stocks and U.S bonds. What was the conclusion of this research as of 1993? Bond investing had provided safe, but unspectacular, returns. Over the history of the United States, those investors willing to take a flyer on risky stocks would have made much more money than bond investors, even when adjusting for the more volatile nature of stocks. With the benefit of hindsight, therefore, only the extremely timid (a.k.a. the wimps) ought to have chosen U.S. bonds over U.S. stocks.
Applying Science and Art to Bonds, Stocks, and Real Estate
Warning: Past performance is no guarantee of future returns. Every mutual fund has such a disclaimer. All of the research summarized by Professor Mankiw examined the past. In 1993, it was true that throughout the past, U.S. bonds had been worse investments than U.S. stocks.
Obviously, investors ought to care about the future not the past. Accordingly, this chapter analyzes the outlook for bonds, not just past performance.
Before starting on our bond journey, a few preliminaries are required. First, we're going to look at only U.S. government bonds. The bond universe encompasses many other bonds including junk bonds, municipal bonds, and many more. Why do we only cover government bonds? Because of the story of the goat.
Two men go to a car junkyard looking for spare parts for a classic vehicle. The junkyard is large, so the owner suggests that the men look around to see if they can find a junked car with the needed parts. Interestingly, the owner warns the men to look out for his pet goat.
During their walk through the junkyard, the men pass a hole in the ground. One of them kicks a pebble into the hole and both are surprised that they do not hear the pebble hit bottom.
As might be predicted, the men forget their spare parts mission and begin throwing larger and larger items into the apparently bottomless hole. After some minutes, and still unable to hear anything hit bottom, they heave a transmission into the hole. Soon afterwards, a goat runs up to the side of the hole, pauses, and then jumps into the hole. Shaken by the goat's apparent suicide, the men return to the junkyard owner.
"Did you find your parts?" the owner inquires. Without mentioning the items they had thrown in the hole, the men tell the owner about the goat that jumped to his death. The owner says, "That's funny, but it couldn't have been my goat, as mine was securely tethered to a transmission."
In the bond world, U.S. government bonds are like the car transmission while all other bonds are the goat. If U.S. government bonds sink in value, they will drag all other bonds down with them. There might be some delay while the other bonds teeter on the edge, and some goats may have longer ropes than others. Nevertheless, if U.S. government bonds decline in value, so will all other U.S. bonds.
What about the possibility that bond prices will soar? As we will see, that is not possible. In the current environment, bond prices can either fall or perhaps rise modestly. The first message in this chapter is: U.S. government bonds will measure the speed and length of any decline in the bond market. Thus, we keep our eye fixed on these bonds.
The second message is: Bond prices move in the opposite direction of interest rates. In other words, rising interest rates are bad for bond owners.
Why are rising interest rates bad for bondholders? This can be confusing, and the reason for the confusion is as follows. Is it better to earn 4% or 8% on a bond? The answer is obvious; the 8% bond is better. So rising interest rates might seem good for bondholders. The answer is exactly the opposite: Rising interest rates are bad for bond owners. Falling interest rates are good for bond owners.
The potential confusion is resolved by clearly separating today's bond prices from future returns on bonds. My friend Chris (the MIT rocket scientist we met earlier) and I recently had a similar revelation in a nonfi- nancial situation. Chris is a great athlete and better than I at every sporting activity we have played, at least until recently. A frigid Boston winter forced us indoors, and we decided to begin playing racquetball. Because I had played a lot of racquetball previously, I soundly beat Chris during our first match.
After the drubbing, Chris was a bit morose, especially given his history of outrunning and outplaying me in a variety of sports. I said, "Losing badly was the best possible outcome for you." When he asked me to explain, I said that he had nowhere to go but up. As we continued to play each other in a series of matches, Chris performed steadily better. Our first match was a short-term defeat for Chris, but set him up for months of steady progress. The worse he did in the initial match, the better his prospects for improvement.
Applying Science and Art to Bonds, Stocks, and Real Estate
A similar situation exists for bonds, especially government bonds. The lower a government bond's current value, the more it will grow until maturity. An old joke asks, what's the difference between men and bonds? The answer is that bonds eventually mature. Not only do all U.S. government bonds mature, they mature exactly on schedule and at a price of exactly $100. Thus, the lower the current price of a U.S. government bond, the more gains to the eventual price at maturity of $100. Lower bond prices mean higher future returns. Similarly, higher bond prices mean lower future returns.
When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.
Another way to look at bonds is to divide current owners from possible buyers in the future. If, for example, home prices were to plummet, that would be bad for current homeowners but good for future buyers. Similarly, a drop in bond prices is bad for current bond owners, but good for future bond buyers.
The decision to invest in bonds rests upon a prediction about the direction of interest rates. Buyers of bonds are betting that interest rates will remain stable or decline. Those who believe interest rates will rise should avoid owning bonds. Accordingly, the mission of this chapter is to examine the future of U.S. interest rates.