This article was published on Dividend Kings on Monday, April 3rd.
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A recession has been top of mind for investors for several months now. And for a good reason.
- Recession Watch Video: A Mild Recession Is Likely Coming Soon.
According to studies from the NY, San Francisco, and Dallas Fed, the 3-10 yield curve is the most accurate recession forecasting tool in history. And right now, it's the most inverted it's been in 43 years.
Which means the highest recession risk in 43 years.
And the economic data backs up what the bond market is saying: a recession could start between July and September.
The economic data says that a recession could begin within two to four months, around July.
Does This Look Like A Stock Market That's Priced In A Recession?
So far, the bottom of this bear market was on October 13th. How often has the market bottomed this far ahead of a recession?
It would be unprecedented for the October 2022 low to be the final bottom, if we get a recession in 2023.
That doesn't mean it can't actually happen. After all, how many oil executives though negative oil prices were possible? It happened in April 2020.
How many bond traders thought risk-free government bonds could fall 50% in two days? It happened to UK 50-year treasuries in September of 2022.
- that week UK bonds traded with 5X the volatility of crypto.
But prudent investing isn't based on hoping and dreaming of very long shots. It's about doing what's most likely to work over the long-term.
S&P Potential Bear Market Bottom Scenarios
Earnings Decline S&P Trough Earnings Historical Trough PE Of 14 Decline From Current Level Peak Decline From Record Highs 0% 227 3180 22.6% -34.0% 5% 216 3021 26.5% -37.3% 10% 204 2862 30.4% -40.6% 13% (average since WWII) 198 2766 32.7% -42.6% 15% 193 2703 34.2% -43.9% 20% 182 2544 38.1% -47.2%
(Source: Dividend Kings S&P Valuation Tool)
Outside of the Great Recession, stocks tend to bottom at 13 to 15X trough earnings.
- historical bear market bottom range of 2,400 to 3,400.
According to Fidelity, during periods of elevated inflation, earnings often fall very little in recessions or sometimes don't fall at all.
However, the market often prices stocks at a lower PE during such times.
- 3,000 to 3,500 is the blue-chip consensus range for the final market bottom.
In other words, a 17% to 35% decline is possible for stocks during the coming recession.
Want To Laugh At The Recession? Buy Bonds!
- Why Timing The Bottom Is Stupid, Reckless, And Completely Unnecessary.
Wall Street runs on probabilities, not certainties, so I NEVER recommend selling all your stocks and trying to nail the bottom.
Remember that the range of likely outcomes is very wide.
My family has a complex risk profile due to a lot of medical bills and health uncertainty for my grandparents and parents.
So did we sell all our stocks and hide in cash? Just because stocks are likely to fall a lot lower before the new bull market begins?
Nope, we have over $1.2 million in the world's best blue-chips and use hedges to protect ourselves from the likely recession freight train that's bearing down on us in 2023.
Today I want to explain why five high-yield bond ETFs are the ideal hedges for the coming recession. Here they are in terms of duration.
- PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (ZROZ) 26 duration 3.4% yield
- Vanguard Extended Duration Treasury ETF (EDV) 24 duration 3.9% yield
- iShares 20+ Year Treasury Bond ETF (TLT) 17.6 duration 3.7% yield
- SPDR Portfolio Long Term Treasury ETF (SPTL) 16.1 duration 3.8% yield
- Vanguard Long-Term Treasury ETF (VGLT) 16.1 duration 3.9% yield
- iShares 20+ Year Treasury Bond UCITS ETF (LON:IDTL) 17.6 duration 3.7% yield (for European Investors).
Why Long Bonds Are The Ultimate "Buy And Hold Forever" Bear Market Hedge
According to a study from Duke, long-duration US Treasuries are the best passive hedging asset you can own in recessions.
They generate the best positive gains while delivering the best long-term positive gains across the entire economic cycle.
US treasuries work better than any other risk-free bond, with the highest negative correlation to stocks.
The longer the duration the more hedging power a bond has.
Duration just means how rate sensitive a bond (or any stock) is.
A 30-year Treasury has a duration of 29.85 if you always own just the most recent one (called "on the run" bonds).
In other words, for every 1% change in 30-year Treasury yields, a 30-year bond will go up or down about 30%.
Year S&P Bonds Cash Long Bonds RSBT DBMF KMLM 2022 -18.1% -13.1% 2.0% -39.4% 21.8% 21.5% 30.4% 2008 -37.0% 5.9% 1.4% 55.5% 24.5% 13.1% 40.4% 2002 -22.1% 9.9% 1.6% 36.9% 31.9% 12.9% -9.2% Average -25.7% 0.9% 1.7% 17.7% 26.1% 15.8% 20.5%
(Source: DK Research Terminal) RSBT, DBMF, and KMLM are managed futures.
In a year like 2022, the worst bond crash in US history, caused by rates rising from their lowest level in history at the fastest rate in 42 years, bonds are not a great hedge.
But outside of stagflation hell periods, there is nothing like long bonds to hedge a portfolio.
Crisis Period US Stocks Bonds Long Bonds Cash RSBT DBMF KMLM December 2021 to September 2022 -25% -14.4% -44.8% 0.6% 28.7% 31.6% 44.8% January 2020 to March 2020 -20% -2.6% 20.3% 0.3% 0.3% -0.8% 13.9% October 2007 to February 2009 -50% 6.1% 24.0% 2.5% 25.9% 13.5% 37.4% August 2000 to December 2002 -41% 33.4% 149.6% 11.2% 78.6% 28.8% 30.4% Average -34% 5.6% 37.3% 3.6% 33.4% 18.3% 31.6%
(Source: DK Research Terminal) RSBT, DBMF, and KMLM are managed futures.
What Kind Of Returns Might Long Bonds Generate During The 2023 Recession? 20% To 60%, While Stocks, Could Fall 15% to 35%
What makes bonds so wonderful is that forecasting returns is very easy, it's all about interest rates.
If you know a bond's duration, then it will almost perfectly track its index Treasury yield.
So what do economists think will happen in the coming recession? According to Toronto Dominion's head of interest rate strategy, 30-year yields should bottom at 1.5% to 2.5% in the coming recession.
- Possibly 0.5% to 1.5% if the US defaults on its debt between June and September.
So what does that mean for these six high-yield long bond ETFs?
- 1.2% to 2.2% yield compression for the underlying bonds
- and 16 to 26 duration, depending on the ETF
- up to 3.2% yield compression in the event of a U.S. default.
According to TD, in the coming recession, these long bond ETFs have a 19% to 57% upside and up to 83% upside in case of a US debt default.
Think these numbers are too good to be true? Don't think that anything can possibly soar this much when the markets are crashing? Let's consider three examples using EDV, the bond ETF I use.
During the Great Recession, EDV soared as much as 60% at the height of the panic.
During the 2011 debt ceiling crisis, it soared as much as 50% while stocks fell a peak intra-day decline of 22%.
During the 2018 recessionary scare, bear market EDV was up modestly while stocks fell 21%, including 17% in three weeks. And even after the market took off, EDV continued rallying for another six months.
During the Pandemic, the ultimate black swan event, stocks fell as much as 34% in a month. EDV was up 16% during that time.
What About 3X Bond ETFs? Or 3X Inverse ETFs?
So if long-duration US Treasuries are the best hedges, why not consider something even more potent? How about 3X inverse ETFs (SQQQ) or 3X long-duration bonds (TMF)?
While these can certainly serve as a short-term hedge, they don't make good long-term "buy and hold forever" assets.
I'm interested in owning buy-and-hold forever assets, so I don't have to obsess over when to start hedging or take hedges off.
"Remember, my son, that any man who is a bear on the future of this country will go broke.” - JPMorgan, 1908
The stock market is the best-performing asset class in history and if you're going to short the market 3X over the long-term you will lose all your money.
What about 3X long bonds?
Total Returns Since 2009
Historically, long bonds deliver about 4% long-term returns, and that's what you can expect if you buy them today.
The starting yield on bonds pretty much tells you the long-term returns.
But note how TMF didn't deliver 3X the returns of long bond ETFs like TLT. Thanks to the much higher volatility, it barely delivered positive returns, due to a 73% crash in 2022 and a peak decline of 84%.
Bottom Line: In The Coming Recession, Bonds Will Be The New Hotness
I'm hardly the only one who is buying bonds these days.
Morgan Stanley, JPMorgan, Schwab, and TD are all going long US treasuries right now.
Why not just own 100% stocks? That's a fine option for a very specific kind of investor, such as someone putting money into a 401K they don't plan to touch for decades.
But if your risk profile is like most retiree's, then some allocation to bonds and other kinds of hedges are reasonable and prudent.
And hedges can make sense for younger investors too. Why?
Because 30% of the time it makes sense to have dry powder available, specifically during bear markets.
And do you know what you can do with the best hedging asset in a recession when it's up 20% to 60%? Rebalance into the world's best blue-chips, during a big sell-off.
In an upcoming video special report, I'll be showing Dividend Kings members exactly how I plan to let the bond market tell me an optimal time to rebalance my excess bonds into stocks.
Why bother? Other than my family's complex risk profile and medical expenses? How about because by being overweight long bonds going into recession potentially will let us buy one to three YEARS worth of stock dollar-cost-averaging within 10% of the final market bottom.
Remember how dry powder boosts long-term returns 30% of the time? When you're sitting on a mountain of excess bonds, which are likely to soar while stocks are falling, that's one of the most reasonable and prudent ways to harness the power of diversification, the only "free lunch" on Wall Street.
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