Friday, October 21, 2011

TIPS Are a Crowded Trade

Ned Davis - founder of Ned Davis Research, a market research firm that I highly respect - has three simple rules for investors:
  1. Don't fight the tape (i.e., when the market is trending in one direction, don't try to fight it);
  2. Don't fight the Fed (i.e., when Fed policy is easy, buy stocks, or vice versa);
  3. Be wary of crowds at the extremes (i.e., when sentiment is overwhelmingly skewed in one direction, be careful).
I have often thought of Ned's rules, but I was particularly reminded of rule #3 this morning, when I read this sentence from an email sent by Brad Hintz, Bernstein's financial analyst (TIPS are "Treasury inflation protected securities"):

Yesterday, the U.S. Treasury sold $7 billion of 30-year TIPS at a record low yield of 0.999%. Demand was very strong as the bid-to-cover ratio was 3.06, well above the average of 2.40. Indirect bidders, a class of investors that includes foreign central banks, purchased 43.2% of the securities, above the average of 40.0% for the past four auctions

Think about that: there apparently is a large enough group of investors so convinced that inflation will be roaring back that they are willing to lock in returns of less than 1% for the next 30 years (!).

I know I wrote yesterday that investors should avoid predictions, but here's one that I can safely make: The world will look alot differently in 2041 than it does today.

So does that mean that bonds are overvalued?

Well, maybe, but I think with the Fed keeping short rates at 0% for at least the next couple of years, and deflation, not inflation, a bigger risk, bonds can still play a role in investor portfolios.

But for investing, it still seems to me that dividend-paying, large cap stocks are the way to go. So too does legendary investor Leon Cooperman, who is not a big fan of bonds.

Instead, Mr. Cooperman likes stocks:

“I wouldn’t be caught dead owning a U.S. government bond,” he said today during a presentation at the Value Investing Congress in New York. “Not because I have a problem with the credit. I have a problem with paying 35 percent on the 2 percent to Uncle Sam, and then have a 2 to 3 percent rate of inflation,” he said. “It’s confiscation of my capital. I think I’m too smart to play that game.” ...

Stocks are cheap relative to history, relative to inflation, relative to interest rates,” he said. “The recent facts suggest the economy is accelerating moderately.”