Stocks Are In Turmoil, But Treasuries Offer The Best Returns In Over A Decade. This Is How To Choose Them

After a dismal 2022 ending with a weak December, the stock market came to roaring life in January. The S&P 500 rose more than 6%, led by sectors previously battered such as technology or consumer discretionary. The stock surge is due exclusively to better sentiment, because the earnings releases of January were disappointing, had the lowest rate of positive earnings surprises since the pandemic, margins weakened and projections for future earnings declined. In stock parlance, the market went up because of “multiple expansion” – a shortcut for “investors are willing to pay a lot more for the same stuff.”

Why did sentiment improve that much? Because the market thought that the Fed had been wrong in fighting inflation aggressively, which many pundits believed it was in clear decline. Therefore, the thinking went, it was just a matter of time for the Fed to reverse course and start easing rates. That thinking neatly dovetailed into the tired narrative of a clueless Fed that can’t get its mind around the real economy.

The market’s conviction that the Fed was going to do a 180-degree change in policy was so strong that Federal Funds futures were, at one point, three quarters of a percent lower than what the Fed itself was forecasting. An odd thing indeed, given that the Fed, not the market, decides the Fed Funds rate.

As it turned out, the market found out that the Fed may not be so clueless after all. Inflation numbers for January came much hotter than expected, both at the consumer and at the producer levels. The saying “don’t bet against the Fed” proved to be true: Fed Funds futures soared above the Fed forecast. The market now expects rates to stay high for the remainder of the year and beyond.

Declining earnings and the prospect of a persistently restrictive Fed are starting to sink in. The S&P 500 flash rally has screeched to a halt, unable to break through the high mark of February 2. Yesterday, February 21, it fell back below the psychological 4000 level.

Still, there are optimists who point that the labor market remains tight, wages are growing (although less than inflation) and retail sales have been strong. They believe that these signs show that the consumer is strong and will carry the economy along while the Fed keeps tightening monetary policy. But is this so? According to a recent report from the New York Fed, credit card balances are at a record high while delinquencies are now higher than at any time in the last decade for all borrowers younger than 60. The consumer, flush with cash when it exited the pandemic, seems to be burning through it quickly.

This is a confusing picture, to say the least. From the humblest retail investor to the most seasoned portfolio manager, nobody has any idea where the stock market is heading. Some, like prof. Jeremy Siegel from the Wharton school and author of “Stocks For The Long Run” believe that stocks are heading for gains, although lately his conviction seems to be weakening. Others, like Morgan Stanley’s
MS
chief strategist Mike Wilson, believe that stock prices are in what mountain climbers call the “death zone” – so high up that they cannot survive at this altitude for very long.

Fortunately for investors, the U.S. Treasury market offers an alternative that can turn a profit regardless of where stocks go, and it is at its most attractive point in a very long time.

U.S. Treasury bills, notes and bonds are guaranteed by the full faith and credit of the U.S. Government. This means that they are exceedingly unlikely to default, so their credit risk is virtually nonexistent. When held to maturity, they return to the investor the stated yield at time of purchase, except for the reinvestment risk of the coupon payments. T-bills don’t have coupons and therefore have no reinvestment risk, and some of the notes and bonds have such low coupons (like the 0.125% T-Note maturing on 1/15/2024) that reinvestment risk is negligible for most investors.

Treasuries maturing by the end of 2023 currently yield more than 5%. This remarkably high yield is the result of the aggressive rate increases that the Federal Reserve has implemented since 2022, and the highest it’s been since June 2007.

The current uncertainty in the stock market makes a compelling case for choosing a U.S. Treasury that offers more than 5% for a year with certainty over a stock market that nobody knows where it’s going. This is especially the case for the shorter maturities that carry the highest annualized yields. Most of other short-term fixed-income instruments like AAA investment-grade corporate bonds have lower yields, and that is also the case for much of the after-tax yield on municipal bonds. More importantly, both have credit risk and far poorer liquidity than U.S. Treasuries.

Some investors, concerned that interest rates may not stay high for long, are flocking to the 2-year U.S. note, despite having a lower yield than one-year Treasuries. My research, however, suggests that, for a U.S. Treasury portfolio constrained to a maximum maturity (say, two years), it is better to pick the highest point of the yield curve and roll over the maturing instruments rather picking the longest maturity. And with the Fed firmly in restrictive mode, the chance that rates will continue to rise is significant, which means that owners of shorter-term Treasuries may be able to roll them over at even higher rates.

For many reasons, even Treasuries that are very close in maturity may offer different yields, as the graph above shows. Sometimes, even the same instrument can have a different yield depending on the size of the trade – an advantage for financial advisors buying a large block for all of their customers over someone buying a small piece. Just-issued T-bills often trade at yields above similar maturity instruments, as is the case with the most recent 6-month T-bill maturing on 8/24/2023 (see graph).

Carefully picking the right Treasury instruments among all the offerings in the yield curve (which means buying the highest-yielding ones around the hump, as I believe) and rolling them over in a timely manner could result in improved returns than just buying any Treasury.

And to obtain those results, market participants must understand that it is essential to buy individual assets rather than bond mutual funds or ETFs. If interest rates continue to rise, the latter will not only underperform but also might lose money, as I discussed in previous posts.