Ned Davis Predicts Bond Funds to Remain Strong in 2020

Bond Funds

Bond funds have had a big target on their back after their peak last summer. Bonds had a great first 8 months of 2019, and the outlook has changed, but not for Ned Davis.

It was no secret that after bonds peaked last August that we were in for a correction. With stocks, you need to wait for enough of a shift in momentum to be able to call a reversal, but in the case of bonds, a correction was written all over the wall in bold letters once we said goodbye to the highs of August and saw significant weakness start to rear its ugly head in September.

Stock prices reflect the market’s future valuations, which doesn’t really have any limits and the enthusiasm that can drive prices can and does keep going over time. Since this bull market started in 2009, we have put up the valuation of the average stock up by 3 times, and there may be even more of this in store in 2020.

Bond prices, on the other hand, are dependent upon what kind of return people are willing to accept for lending their money to bond issuers, which definitely has its limitations. We saw such a limitation in August after a stellar year to date, driven mostly by the lower than average but still superior returns of U.S. bonds relative to those from other countries.

Even this scenario has its limitations though, as we clearly saw. While we see remarks such as the economy stabilizing more and the situation with the trade war improving, it is not that these situations have even changed that much since, and therefore this cannot be a sufficient explanation for the benchmark iShares 20+ Year Treasury ETF giving back 8% of its gains to end the year.

What really caused this is the correction from the overbought situation that peaked back then, and like stocks, bonds are also subject to the phenomenon of profit taking. When stocks approach all-time highs, we see some of this, but most people continue to hang on in hopes for more, which often buffers the downward forces that profit taking exerts.

We still can see some pretty good sell-offs with stocks though, because such a high percentage of actively traded shares are in the hands of traders, who are in it for a good time, not a long time, and will not hesitate to get out when we see the momentum tip and then start to reverse.

The forces on the sell side increase until it overcomes the current buying pressure, and once it overtakes it and starts to send price the other way, more traders pile on and a new trend is established.

To see how this works in its pure form, we only need to look at the sell-offs with cybercurrencies after this massive move tilted the wrong way. With nothing of value to stop it, the sellers were unopposed, and there was a lot of them and the move down was simply massive, as the rise was.

Stocks, on the other hand, have a backstop, the point where the price drops to the point where enough interest is generated based upon the company’s valuation to reach equilibrium. These moves down generally are overexpressed, and markets are constantly in a state of moving between overbought and oversold conditions to some degree, even minute by minute, as overenthusiasm in both directions get corrected.

While traders dominate the stock market, they dominate the bond market even more, and we only need to look at this 8% downward move to show how much. Once again, conditions really haven’t changed that much since, other than people pulling a bunch of money out of negatively yielding bonds, which simply isn’t sustainable over time and is reflected of a very overbought condition, which actually stimulates demand but wilted in the face of the opposing force of bond traders.

Bonds Became Very Overbought, and are Still Overbought Right Now

These bonds simply grew too much in price and while you can make good money trading these things as they rise in value, when we well surpassed sustainable levels, that’s a big red flag, and it then becomes just a matter of time before the reversal comes. Buying a negative yielding bond only makes sense if you’re only planning on holding it for a while, while the price is going up, and when it goes down, it no longer makes sense for anyone to hold these bonds, especially for traders.

U.S. treasuries have not even come close to negative yields, and this is not even in the realm of possibility right now, even though some have entertained the possibility lately. We have already danced this yield limbo in August though and provided that things remain stable, that’s a dance that we may not even repeat for a long time.

The key here is that bonds most certainly have caps to their upside, and when you’ve reached one as we have, this really limits our potential gains, even to the point where we may be all but assured of simply losing money on the deal.

We didn’t even have to see the reversal at all to predict how this would all end, as bonds simply could not have gone much higher once they approached all-time high levels. Much of this move was driven by speculation, and if you think traders dominate stock markets, they dominate bond markets even more, and the very fact that yields can be dunked underwater and kept there for some time is all from the forces of traders, because it is simply foolish buy an investment that is guaranteed to lose on their time horizon.

Price speculation is all we have here, but it can be a mighty force indeed, and we saw that to a lesser degree with U.S. bonds as well. That party ended though, and we’re left with cleaning up the mess, with the questions now pointing to how this market may perform in the coming year.

Whether our goals are to speculate on bonds, to try to use them as a hedge, or to try to use them as fixed income assets, the state of the market has to matter to us. A new year brings on fresh outlooks on everything, including bonds, and research firm Ned Davis is stepping up to try to calm some of the anxiety out there right now.

The consensus view is that 2020 will be mildly bearish for bonds, even though bonds don’t really go beyond mildly bearish that often, save for unusual situations such as we saw in September, with all indications pointing to a significant slide in the coming months. We’ve taken that hit already, and we’re left to wonder now much more of this may be in store.

If we are wondering how much we may lose, and the prospects of making money on bonds in 2020 remains dim, this is a time where we need to ask ourselves what justification we may have for buying or sticking with bonds in 2020. The idea behind investing is supposed to be to make money, not hope your losses are limited, and anything that has a negative expected outcome should be shunned without further question.

As the price of bonds has risen, yield seekers have been pushed out of the way by the swarm of traders, and the effect of the loss of demand from bond investors became overwhelmed by the extra demand from speculators who were hoping that yields declined further, and make money from this.

We Lose Money When Yields Rise As They are Expected to Do

When we invest in bonds, we are actually hoping that the yield goes down while we own them, and it’s actually necessary to see this lest we suffer a capital loss. Sure, the interest payments we get from bonds will offset this, but they are already very paltry and requiring them to offset capital losses makes them even more so.

Yields are expected to rise by everyone, including Ned Davis, although they are predicting that this rise will be much more modest than most think. That should be enough to turn us off from them though, and this is like recommending an investment that probably won’t lose much and that’s supposed to have you want to invest.

If it were down to deciding between bonds and cash, and the yield with bonds is already so low that cash already is pretty close, and you probably will lose capital over the next year, this makes cash an even better option, given that you can buy a CD and be guaranteed that you won’t lose capital and end up with a negative return overall.

Ned Davis points to all the inflow of funds into bonds that we saw in 2019, but this is not an instance where we want to be trend following past the point where the trend has ended. When it has, it does not matter what the inflows may be as we see the value of bonds being sucked out before our eyes.

This is a case where we are taking a single influencer of bond prices and are trying to blow it up so that it looks big enough to be influential, even decisive, where the truth tells a different story. Doing our best to ignore reality is not the path to truth.

Sure, more and more people will be looking to add bonds to their portfolio as they age, as Ned Davis points out, but this is a slow process which has very little effect on the bond market in the shorter-term, the one that we are looking at when we try to assess how 2020 will look.

Ned Davis sees investor demand continuing to increase as the last foothold for the bull market in bonds, but overestimate its influence. This is an easy one to put down as this force certainly didn’t stop the 8% loss we’ve had in the latter part of 2019, and won’t do much to dampen things going forward either.

It is not that this extra demand doesn’t matter, it is that it can be dwarfed by the traders, as it is right now. Ned Davis predicts that yields will remain stable in 2020 though, meaning that the price won’t go down, or won’t go down much if their prediction ends up ringing true.

If we want to be in bonds, even if this is true, it is not good enough, as we really need to be paying attention to capital growth much more than we do with bonds, and we should wish to actually make a profit on the price of them like we do with stocks, even though our aspirations here need to be modest due to the fact that bond prices move more slowly.

When we’re looking at what the expectations are for this year, we need to take the yield from the interest that we will collect and deduct our expected capital losses when that is the expectation, which it is right now in spite of what Ned Davis thinks, where we likely will end up with a net expectation overall.

When your fund loses 8% in spite of collecting these interest payments, over a period of just 4 months, this should tell you that the couple of percentage that you earn in interest from these debt instruments can be easily toppled and you can lose money instead.

Bond prices have stabilized more, and the damage here was all done in the first two weeks of September, but attempts to turn things back in the right direction have all failed so far, and the outlook right now is anything but bullish.

We still have a lot of the forces that caused the bull market still in place to some degree, with foreign investors still flocking to the U.S. bond market, but this has already peaked and may continue to wane at least somewhat.

While things don’t look as bad as they did in late August, as the piper has already extracted a considerable price for our excesses, and based upon what we know right now, this bill has not been paid in full yet. This tells us that the expectation for bonds in 2020 are negative, and regardless of whether this negativity will be mild, mildly losing money surely cannot be the real goal here.

If we enter here, or if we are in and choose to stay, which is essentially the same thing, it won’t take much more of a decline to simply wipe out our income flow and have us reaching in our pockets to pay for this mistake. Investments should be paying us, and while sometimes we do have to pay instead, this should be by accident and never on purpose.

Even if you are planning on holding these things for 30 years without question, it does not ever make sense to buy them until this outlook changes to positive. It doesn’t even make sense to hold them during such a time, if the expectation for a significant period such as a year is negative enough to have you just throwing money away. You can get back in if you want when the weather improves.

When the expectation is such that putting your money under your mattress wins by even a little, it is time to rethink things.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: [email protected]

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