“Investing is the only business I know that when things go on sale, people run out of the store” – Mark Yusko
James Montier is one of my favorite writers, and his research pieces are some of the few must reads on Wall Street. In his recent piece, Seven Immutable Laws of Investing , his lists Rule #5 as “Risk is the permanent loss of capital, never a number”. Long time readers know loss of capital is a big focus of my research. I am a trend follower at heart, however, I realize there are other techniques that offer both non-correlated as well as abnormal risk adjusted returns (such as reversion and fundamental factors).
One of the risk factors I think a lot about is drawdown, and specifically how much drawdown is enough to warrant a position in an asset class or security? The Wall Street graveyard is littered with the carcasses of traders who caught a “falling knife” and bought into a declining security only to watch it decline further. I’ve done a lot of posts on certain reversion strategies before (what to do after a really bad month, etc).
Any individual security can decline 100%, and every major G-7 equity market around the globe has declined at least 75%. The difficulty with investing during drawdowns is that they can always get worse. Also, mild drawdowns can lull investors into a false sense of security. How does one know when to “buy when there’s blood in the streets” like Baron Rothschild is credited with claiming or wait until it gets worse?
With all the recent news on bonds I got to thinking their drawdowns. When even the bond king Bill Gross hates Treasuries you know they are an unloved asset class (note this would have been a good idea months ago rather than now but I digress). ( Shilling is the notable bullish exception on bonds.) When Bespoke did their year end blogger roundtable the only consensus was that everyone hated bonds. This Fortune Magazine article titled, “How to Navigate the Bond Rout” is littered with people hating on bonds. This table from the article is a sample of the current feeling on how bonds are going to get crushed:
Click on any of the tables/charts to enlarge them.
(Now, remember this math works both ways – if interest rates go from 4% to 3% a 30 yr bond appreciates about 20%.)
This sort of strong opinion usually gets me interested so I set out to take a look at US government bond returns and their drawdowns using all the data Global Financial Data has to offer. Below is US 10 year bonds, and as you can see they usually don’t have drawdowns worse than 10-15%.
Chart 1 – US 10 Year Bonds Total Return with Drawdowns Since 1800
Chart 2 – US 30 Year Bonds Total Return with Drawdowns Since 1919
Longer maturity and duration 30 year bonds are of course more volatile, but usually don’t have drawdowns worse than 20-30%.
Chart 3 – US 30 Year Bond Yields with Drawdowns Since 1953
And below is an example of drawdowns for the long bond during the interest rate period where yields went from 2.6% to 15.2% (could be eerily similar to now).
Nominal Returns for 10Yr US Govt Bonds, 1900-2009
Nominal Returns for 10Yr US Govt Bonds During Rising Rates, 1953-1981
Nominal Returns for 10Yr US Govt Bonds During Falling Rates, 1982-2009
Real Returns for 10Yr US Govt Bonds, 1900-2009
Real Returns for 10Yr US Govt Bonds During Rising Rates, 1953-1981
Real Returns for 10Yr US Govt Bonds During Falling Rates, 1982-2009
Nominal Returns for 30Yr US Govt Bonds, 1919-2009
Nominal Returns for 30Yr US Govt Bonds During Rising Rates, 1953-1981
Nominal Returns for 30Yr US Govt Bonds During Falling Rates, 1982-2009
Real Returns for 30Yr US Govt Bonds, 1919-2009
Real Returns for 30Yr US Govt Bonds During Rising Rates, 1953-1981
Real Returns for 30Yr US Govt Bonds During Falling Rates, 1982-2009