Red Lines

What if nothing happens after you've crossed one?

Cambria’s Emerging Shareholder Yield ETF, EYLD focuses on companies in emerging market countries that are returning cash to shareholders through dividends, buybacks, and net debt reduction.

A lot of times there are supposed “red lines” we are told cannot be crossed but then we cross them anyway and nothing really happens. Or the opposite thing than what we’d expected to happen ends up happening.

In August 2011, when the US Treasury was downgraded from its vaunted Triple A status by ratings agency Standard & Poor’s, it seemed like a big, bright red line had been crossed. What would the ramifications be? This was, after all, something that had never happened before.

Wait, the Steelers gave LaMarr Woodley sixty million dollars?

Before it happened, the idea of the United States Treasury Bond being rated as anything other than AAA seemed inconceivable. If the US government was on shaky ground, what borrower could you possibly imagine as being on solid footing? No one knew what this would do to bond pricing across markets but a negative overreaction was certainly one conceivable outcome. A domino effect knocking down one asset class after another as risk was repriced around the world was another reasonable guess. It was hard to guess at what might happen, but “nothing” was probably an outlier prediction. “Treasury bonds rally” would have seemed an even more outlandish call.

So we braced for whatever was to happen next. Turns out “nothing” and “Treasury bonds rally” were the right call.

I guess we had that backwards

Here’s a look back at how the 10-year Treasury traded that summer, before and after the downgrade:

Remember: Falling yields mean rising bond prices :)

So the global response to the first-ever downgrade of the US Treasury bond was a viciously acute rally no one could have expected. Why?

Rising Treasury yields in the United States don’t signify a concern that the US cannot pay its bills. When bond interest rates rise here, it’s a signal of economic prosperity. However, when the rates spike in a country like Greece or Italy, it’s probably because the buyers won’t buy as the rate needs to be higher to account for the risk of non-payment. So if you think the US is in economic trouble, you would expect Treasury bond rates to fall, not rise, therefore the bonds’ prices would be rallying.

That was the summer the markets were reminded that the United States is not Greece. In times of stress, you sell Greek bonds (rates rise) and you buy US bonds (rates fall).

US Treasury bond interest rates rise during times of economic expansion and they fall during times of sluggishness or recession. Of course rates should fall after a ratings downgrade. When I explain it now, all these years later, it sounds so obvious. If they cut their rating on the Treasury bond, you buy the Treasury bond. Duh.

Back then, it didn’t seem so obvious. All over Europe, sovereign bonds were seeing interest rate spikes in response to ratings downgrades. It was a weekly occurrence. It makes sense that we would have expected a downgrade of the US bond to result in something similar. We thought it was another red line.

More Red Lines

During the spring and summer of 2016, Donald Trump wiped the floor with ten different potential candidates for the Republican nomination for President. One by one he took them out, so many that they needed to have multiple nights of debates just to put them all on stage. But he crushed the field. How? Saying things out loud that no other candidate before him had ever dared say. He crossed every red line in the book and then invented a few more we hadn’t even thought of - stepping over each in turn, on every occasion, in every setting. Saying John McCain is not a real war hero because he got captured was f***ing crazy at the time. For any other candidate in any other era - either party - that would have been the end. It wasn’t. Refusing to publicly release his taxes or his financial information seemed equally red line-ish at the time. “How can he not do that, every other Presidential candidate in history has…?” Oh well, guess that line isn’t really there either.

It didn’t matter how many norms he violated or supposed lines he stepped across, there just wasn’t a Tiburon wide enough or deep enough to stop his advance. His strategy for standing out amid a a gigantic field of candidates was to break all the rules and grab all the attention away. Once he became the only thing people were talking about, all the campaign spending in the world couldn’t save Chris, Carly, Jeb and the others. They were all playing by the old rules, stopping short of the line. Donald Trump played as though he didn’t even know the lines were there, knocking everyone on their asses and disorienting the commentariat and the press alike. “How is he doing this?” Game over.

To this day, when you ask most Trump fanatics what they like about him, it’s his willingness to cross lines and introduce volatility into a political process they loathe and distrust to begin with. Which is why all the investigations and trials and raids and attempts to disqualify him seem to be, perversely, having the opposite of their intended effect. Do you have to make him answer for the riot he started on Capitol Hill? Yes. Do you have to accept the fact that it won’t make him any less popular among his supporters and may even, in fact, galvanize his appeal in their eyes? Also yes.

These red lines you once believed existed are vanishing right before your eyes. One by one they are revealed to have been nothing more than ephemeral notions of civility and fairness. A puff of smoke, dissipating in a mild breeze. There was never any border or bulwark there. Just a hint of “don’t do that or else.”

Or else nothing.

People around the world took note. So did Elon Musk when he told the SEC to ____ his ____ on Twitter or when he did drugs with Joe Rogan on YouTube. No CEO of a publicly traded company has ever gotten away with that because no CEO of a publicly traded company has ever tried it. Or even thought of it.

The crypto people stepped over every line. There is no banking or anti-money laundering or securities law on the books they didn’t violate. And not just once or twice. The entire existence of Bitcoin flouted both the word and spirit of the rules. Its proponents woke up each morning on the wrong side of the red line and with every investment and project they stepped further away from it. And yes, a few went to jail and bunch of others got sued. But in the end, they won. It’s a trillion dollar asset class, never going away, now accessible in every brokerage account in America and via exchange-traded fund on the New York Stock Exchange.

What red line? Saying “f*** you” to the norms and the boundaries has literally given birth to an entire industry. Bitcoin’s primary use case is speculation, even after fifteen years of trying to make it do something else. It’s secondary use case is humiliating people who refuse to accept its existence. You need a third?

5% 10-Year Treasury Bonds

These days we keep hearing that the 10-year Treasury bond hitting (or crossing) 5% would represent some sort of a no-go zone, or a red line beyond which the stock market would surely suffer. The theory is that being able to lock in 5% over a ten-year time horizon would be a much more appealing option which would lead to huge flows away from more highly valued stocks and into fixed income instead. It’s the threat of an asset allocation trade-off on a massive scale. Maybe.

Rather than guess and cry about it, here’s what history suggests. We took a look at the last five decades of S&P 500 performance through all 3 month and 6 month periods to establish a baseline of average returns. Then we isolated just those periods of time after which the yield on the 10-year Treasury bond had climbed to 5%. That started the clock.

Here’s what happened to stock market returns in those instances:

This is one of those things where the data is definitive: Stocks struggle over the short to intermediate term when rates on the 10-year cross that red line.

My research associate Sean Russo notes that on average, since 1978, forward 90-day returns for the S&P 500 are 2.3% while forward 180-day returns are 4.8% for ALL periods. But after the 10-year crosses 5% to the upside, forward 90-day returns fall to -1.8% while forward 180-day returns drop to -5.8%.

This is a red line that has actually been meaningful through time. You can see it as clear as day.

Now, you will often hear the trope that small cap stocks are actually more susceptible to falling while rates rise because of the degree to which they have floating rate debt or might struggle to roll their loans and bonds over at prevailing rates. There is truth to this but it doesn’t necessarily manifest itself in the stock market or the effect is less pronounced as a result of the 10-year. Perhaps it’s overnight rates that have a bigger effect on smaller capitalization companies, because here’s our data for the Russell 2000 index versus the 10-year:

  • On average: forward 90-day returns: 2.5%, forward 180-day returns: 5.1%

  • After the 10-year Treasury crosses 5% to the upside: forward 90-day returns: .2%, forward 180-day returns: -4.1%.

Sean found that large caps were actually harder hit by the rise of the 10-year beyond that 5% red line.

Yesterday’s retail sales number and the CPI from last week, employment number from the week before - all of these reports are coming in hotter than expected and driving up the 10-year Treasury’s yield.

This rally in rates since the beginning of the year runs counter to what the market’s consensus expectation was at the start. Surely the stock market has survived 5% 10-year rates historically. It’s the initial crossing above that level that has historically led to trouble in the short-term.

Which perfectly explains precisely what’s playing out today. A red line looms ahead and stocks are selling off in anticipation of the crossing. Unlike many red lines we imagine are there when they’re not, this one really seems to matter.

We’ll discussed this and a lot more on an all new episode of What Are Your Thoughts last night. You can watch it here if you didn’t catch it live:

That’s it from me today, talk soon! - Josh