Goldman Sachs Predicts Mini-Bear Market for Bonds

Goldman Sachs

We’ve been speaking about how risky bonds are right now and to expect a significant pullback. Few bond investors really understand even why such things should matter to them.

It takes very little understanding of bonds or markets to get why the run-up that we’ve seen with bonds over the last year should concern us, but you do have to grasp the basics to get this. We’ve written a few articles on this topic lately, and the risk out there right now is already pretty well known among those even a little in the know, and we’ve seen the expected pullback start already.

This knowledge doesn’t really make it to the general public very much though, and the fact that almost all of the talk about bonds is about yields tells a big part of the story right there. Many have complained how low yields have gotten, and presumably hope that they start going back up, and don’t realize that they have all of this backward.

When you’re looking to invest in bonds or are thinking about doing so, it is critical to understand that there are two variables with bonds, the price and the yield. It is actually only the price that matters, and looking at yields instead will only lead to confusion. If you are holding bonds, you want the yield to go as low as it can and stay there, although these people line up to complain about it and get happy when yields rise and the value of their bonds goes down.

An even bigger issue, and one that we’ll tackle in more depth in this article, is the more even fundamental misunderstanding of the utility and opportunity cost of bond investing. Bonds are a terrible investment right now but they are pretty terrible generally, and do have their place but only in certain situations.

This is not how investors use them, and in fact, the investment industry has always promoted bonds significantly, where just about all investors are told that they should hedge their stock positions with a certain percentage of their portfolio in bonds. This is nonsense, but nonsense is not a barrier in the world of investing. This one does stand alone in this regard though and is the most stupid and harmful thing investors do by a long shot.

Whenever we are in an investment, the task is to look at both the upside and the downside, the potential returns and the risk, and look to achieve the best mix of both, or at least one that makes sense. Hedging stocks with bonds or using bonds as a source of return is something that is very inappropriate generally and only is useful in the right hands in the right situation.

If you aren’t one to want to time your investments, bonds aren’t for you, period, no matter what kind of investor you are. We actually have had one opportunity in recent times where bonds were a good idea, which was during the stock pullback of late last year. Bonds for a time outperformed stocks, and this is the only reason why we ever want to be invested in them as individual investors, although the expectations with bonds still need to be favorable. With stocks and bonds going in different directions, this ended up being a good time to do it and it did pay off a little.

This obviously requires that people time their stocks though, which is something not a lot of investors wish to ever do. Regardless of the opportunities that we have to help ourselves by doing so, as far as this may be from optimal, it is not unreasonable at all that so many choose not to under the circumstances due to both a lack of interest and aptitude.

It is what happens when we want to be in bonds but refuse to manage our investments actively that is the real problem, and this approach is not reasonable at all. Last fall, the mood of the market soured and we actually got into a fairly rare situation lately where the outlook for stocks was poor and the outlook for bonds was quite good, but this does not happen very often.

Taking some of the money that you have in stocks and putting them in bonds during these times can be pretty wise indeed, and the goal here isn’t to make money overall necessarily, but to hedge your risk with the stocks.

Typical Stock Investing Ignores Risk, Bond Investing Ignores Return, in a Way that Is Much Worse

There are two things that are required for you to hedge something, which is the risk climbing too high and the prospects of the hedge to provide a positive return being good. If both stocks and bonds are bad, you have to look elsewhere for a hedge, something that is moving the right way.

The 2008 crash was not a time where we would have really wanted to move to bonds for example, even though a hedge was certainly needed. Other than the first two months of 2009, where the downward move peaked, we only really saw a loss of about 50% of the value of stocks. Bonds only went down by about 25%, so that’s better, but it’s just better not to chase a losing proposition and instead seek something else, even though the only reasonable alternative may be fleeing to cash.

We’ve had a bull market with stocks ever since, and the only pullback of any real note was the 20% of late 2018. There was your opportunity if you wanted to hedge with bonds, but this did require a good sense of where both were headed, and if you do not have a good sense, it doesn’t make sense to do something lest you miss more than you hit and cost yourself money.

There’s no better way to cost yourself money than using bonds as a perpetual hedge though, bar none. If you are committed to a buy and hold strategy, you’re not managing risk at all, but at least you are shooting for the good returns that stocks provide over time. If you aren’t going to time your investments, you aren’t going to be able to hedge strategically because that requires timing your stocks, so what people do instead is just hold a certain amount of bonds for the hedge.

Just how bad this approach is escapes just about everyone, and to suggest that long-term buy and hold investors should not ever buy and hold bonds no matter how old they are goes against the advice of virtually the entire investment industry. Sometimes there is strength in numbers, but this is not one of these cases.

The best way to explain just how bad this type of hedge is, if we can even call it a hedge that is, is to look at how bonds perform over time compared to stocks. We’ll take the oft-referenced iShares 20+ Year Treasury ETF to illustrate this, which involves us investing in what is considered to be a risk-free investment.

It might seem that there should be no better hedge than a long-term treasury ETF, and if we just look at the risk side of things, treasuries are certainly less risky than stocks. They are actually riskier than we tend to think though, and when they become overbought like they are now, this really comes home to roost.

It is actually not unusual at all for this fund to experience what we could call mini-bear markets, pullbacks of a magnitude that may not alarm us too much with stocks, but really need to with bonds, since bonds have so much less upside.

They do tend to come back, although it usually takes quite a while to get back to even and all the while you are subject to an overall return that is just terrible. It’s the terrible returns that do the real damage with bonds in fact.

The 25% drawdown from October 2008 to January 2010 was a pretty big one, relatively speaking, and wasn’t really that big of a surprise even though many might think that we would have gotten a flight to bonds during these troubled times. People were worried about both stocks and bonds back then though and the smart money flew elsewhere.

We made it back in April 2012, and actually went a little higher than 2008, an all-time high for the fund in fact, but unlike stocks, when bond funds make all-time highs, which we had in 2008 as well, it’s really time to head home. By October 2013, things dropped by 19%, for no good reason other than people sold off this much.

April 2016 saw things come back all the way and make another all-time high, but by July 2018, we gave back another big chunk, 18% this time. Last July was the start of another run, which peaked this last August with another all-time high, and we’re already off by 3% since then, and this party is just getting started.

When you see a treasury ETF gain more than the S&P 500 has during the last 12 months, with the S&P 500 doing fabulously over this time, this should really alarm us. This has actually happened, with the bond fund up 25% with the S&P only gaining 20%.

A Bear Market May be Coming with Bonds, But Bears Already Rule this Den

When you read in the news how low treasury yields are, this means that they are worth a lot more, but when bonds go up a lot, they head back down a lot. We might not even see this fund’s price make another all-time high for many years, and those who still hold it are destined to ride the roller coaster down.

This is not lost on Goldman Sachs analysts, who have just predicted a “baby bear market” for bonds. This might not even be a baby one, and the other two that happened during the current bull market for stocks were very close to hitting the 20% threshold that we call a bear market with stocks. This one might actually get there.

It’s not a matter of how far this will drop over the next while, it’s much more about bonds being bearish overall, and bonds deliver such awful returns that they are already terrible enough unless you are riding one of the waves up that we just saw. Once you surpass the crest, as we did this summer, it is time to get off.

Since we view bonds as a hedge, we need to be asking what sort of hedge this actually is. Often, including right now, we should actually be hedging the bonds with stocks, although unlike stocks, the upside isn’t there or anywhere close to justify taking the risk when things aren’t going well and we need to instead just get out.

The biggest risk with this strategy is the risk of very high opportunity cost when using bonds as a perpetual hedge to stocks, and all we have to do is look to the past to see just how high this cost actually is. Financial risk is a risk of losses, and the risk of the loss of a massive amount of missed profit is enormous as well as virtually certain.

This particular ETF has been around since 2002, and has averaged a 3% annualized return over this time. It was actually down to 2% per year last year and only grew this big due to the big rally we had, which is headed for a reversal. The S&P 500, by contrast, has averaged a return of 21% per year over this time.

The opportunity cost of the fund is therefore an eye-watering 18% per year, and no matter whether we have put 10%, 50%, or 100% of our portfolio in this, we have lost this much with it. 2002 was quite a while ago of course, and that’s a lot of years and a whole lot of losses.

What did we get back here by hedging this way? The only time that the risk with stocks got hairy was during the 2008 crash, but these buy and hold sorts are long-term investors who stuck to their guns and before too long, all was made well and the good times resumed. We paid that much each year and the only thing on the other side of the ledger over these 17 years was a 25% relative performance that was just temporary.

That’s so far from being worth giving up 18% a year for that it should boggle our minds. 18% times 17 years is an overall loss of 307%, paid for the privilege of saving ourselves 25% one time and only for a short period, where the savings ended up being merely an illusion and was quickly erased and reversed.

Since then, stocks have gone through a 18% drawdown or more once, while bonds have seen this happen twice already and they are primed for a third. This does not even manage risk in an effective way and if anything adds more overall while cutting our returns by 86%. That is simply crazy.

There was no benefit at all from this hedge in fact, and all we have to show for our mistake is the 18% loss a year. This loss is real even though it does not involve a nominal loss, but missing out on 18% a year is a huge loss, each and every year. When we ask ourselves if the benefit that we are getting from this could possibly be close to justifying the huge cost of this, we need to be shocked and disgusted.

This has been during a long bull market though, and we’ve seen long bear markets, and this at least makes it possible to actually come out ahead with this sort of hedge, but managing this like a blind trust where the great majority of the time this fails, leading to it failing massively overall is the opposite of sensible. It is not that bonds don’t work as hedges, it is that they only make sense at certain times, and a bull market with stocks is not one of those times, to say the least.

Now that we’re at a point where there’s virtually no upside and quite a bit of downside, maybe even 20% or more, this twisted hedge makes even less sense. People investing in bonds right now for any purpose, or individual investors holding them, are making horrible bets, and holding something is keeping your bets and money on the table the same way as a new investor does.

Opportunity cost is a central concept in economics, where we actually need to compare alternatives to seek out better solutions, although if we just flat out refuse to compare, we are not even focused on success. While this impacts all investment decisions, there is no bigger failure to recognize opportunity costs as there is not bothering to compare stocks and bonds properly.

If we end up with another long bear market, then the time may come to use bonds this way, and it’s a lot better to be eking out 3% than losing a whole lot more where it may be many years before we get back to even. We should ideally be out of stocks entirely while this is going on, and all in with bonds, but unless this is happening, being all in with stocks is the only thing that makes sense.

If you aren’t up for timing things, this is out of your league and even beyond your willingness to help yourself. Stocks go up most of the time, so any strategy that has you dead wrong most of the time, which is what happens with no opportunity to differentiate, is just plain dead wrong.

There is a lot of money made with bonds by those who actually seek to be in at the right time and out during the right times. Investing long term in them during stock bull markets is the worst time, and using this strategy with no regard to the appropriateness of it is the worst approach, but if we don’t even wonder about the decision, we may never realize this.

Eric Baker


Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

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