Different Drummer Investing
May 29, 2005

Different Drummer Investing

Austin, Texas. Economist Lacy Hunt and money manager Van Hoisington have a multi- billion dollar bet that long term interest rates will decline further. It's what they believed two years ago. It's what they believe now.

In the interim, they have been very lonely. The consensus was that interest rates had bottomed, that the long secular bull market in bonds was over, and that long bonds were vulnerable.

But they were right. The consensus was wrong. In 2004 the Wasatch-Hoisington Treasury fund (ticker: WHOSX) returned a startling 10.22 percent. As of mid May the same fund had returned another 8.61 percent, propelled by a mix of long term Treasuries and zero coupon bonds, as long term rates continue to decline even as the Federal Reserve continues to raise the federal funds rate. As they expected, the yield gap between the longest Treasury maturity and the 10 year Treasury is down to 35 basis points. They believe it is on its way to the long term average, 10 basis points.

How can this be, I asked Mr. Hunt.

Seated at a large conference table, not far from a bank of large computer displays and a wall of glass overlooking the Austin hills, Mr. Hunt dropped a now familiar stack of economic graphs on the table. Hunt and Hoisington share what might be called 'data tenacity' because their decisions are carefully grounded in stacks of graphs and the interpretations that connect them.

And that may be where the difference is: their interpretation.

"The 'conundrum' thing of Greenspan," Mr. Hunt said, referencing an odd word in the Fed chairman's testimony, "is that long rates are a function of short rates. But the alternative theory is rational expectations--- that long rates respond to what is expected…"

"The yield curve (a curve that charts yields versus maturity) is, by itself, a leading indicator and a coincident indicator. It's also very robust. When the yield curve flattens, it reduces lending opportunities. By robust I mean powerful and reliable. It's something not to be ignored.

"It's telling us to expect slower growth and less inflation."

"Our basic theory is that the economy is in an interlude in which the coincident indicators tell us the economy is strong, but the leading indicators are turning down."

How far, I asked.

"We don't need to know. It just tells us that growth will be materially slower later this year."

One bit of evidence that he mentioned is the decline in mortgage refinancing applications, now below the previous year level for 20 consecutive months.

  Mr. Hoisington lays a single page on the table, the "Cash-out Refi Report" from Freddie Mac. It shows home equity cash out financing of $139.5 billion for 2004. No one knows how much money is really involved, he points out, because different sources come up with differing figures. Whatever the actual figure, however, home refinancing is a big stimulus to consumer spending. And it's going away.

"We've got a synchronized decline in leading indicators," Mr. Hunt adds. "We had that going into the (first) war with Iraq. Worldwide weakening is evident in coincident indicators. England, for instance, is growing only about a third as fast as we are."

I asked if they thought the Euro would come apart.

"We don't think so. But the dollar is strong relative to budget deficits, trade, work, and monetary conditions. If you look at those factors all are in favor of the dollar…"

While Hunt and Hoisington watch different economic measures month to month, the real difference is that they view them in a much broader historical context than most economists, market analysts, or media people. Mr. Hunt pointed out, for instance, that virtually no one has paid attention to the velocity of money for years but it is becoming important once again. "If velocity is stable, money growth becomes important. If velocity is in a downturn, money growth is even more important," he said.

As they see it, we're at the end of one of the three investment-led economic expansions in the last 150 years--- the railroads, the assembly line and electricity, and computerization. "Investment creates productivity gain," Mr. Hunt observed.

The same productivity gain is why employment is still below pre-recession levels--- corporations haven't needed to hire as many workers. As a consequence, they point out, the employment cost index is registering the lowest growth since the index was started and the inflation trend is still downward.

They also believe that the fall communism reopened a vast global labor market that will put pressure on wages for years to come.

Finally, there is the problem of debt. "We've looked at this repeatedly and we've concluded that when interest rates go up, they can't stay up."   There's just too much debt out there, most of it at variable interest rates."

Couple this with relatively high price/earnings multiples and low dividend yields for common stocks and they see an uncomfortable future: modest equity returns, and still more decline for interest rates.

Neither Hunt nor Hoisington will venture to guess how low they can go. History, however, tells us that the 20 year Treasury has yielded less than 4.02 percent in 10 percent of the quarters since 1957, well below their recent yield of 4.5 percent.

On the web:

Hoisington Management website (Quarterly Reports)

Animated Yield Curve

Tuesday, March 14, 2003: "Another nail in the equity coffin?"

Sunday, February 23, 2003: "Will rising debt stall recovery?

Tuesday, February 9, 2002:   "Recession may not end soon"

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