In 1981, Richard J. Hoffman, then chief investment strategist for Merrill Lynch & Co., forecast what he called "The Dawn of the New Bull Market."
At the time, his outlook for steep interest rate declines and the favorable environment that would be created for fixed-income securities seemed almost ludicrous. Double-digit interest rates had reached 15 1/4% then and were expected to climb even higher.
"We made the call at 15 1/4% and interest rates went up further to 15 1/4%. In the first 12 months of the call, people thought we were crazy," Hoffman recalled.
Now Hoffman, managing director and chief investment strategist at Cowen & Co., a New York City-based investment banking firm, believes bonds have seen their heyday, at least for the near term. His latest call is for the end of bull market.
While Hoffman forecasts the downturn to take about 18 months to evolve and several years to play out, now is the time for long-term, total-return investors to decrease Treasury bond holdings and to begin positioning for the market's decline, he warns.
Hoffman predicts the following scenario: Within the next 12 months, long-term interest rates could hit 8% as they move toward eclipsing 10% by 1995 or 1996. The inflation rate, now hovering around 3%, will begin approaching 4 1/2%. Meanwhile, equities will flourish, signaling a cyclical economic rebound brought about by the deleveraging of the late 1980s and early 1990s.
As a finance professional, Hoffman has been on both sides of the fence. Prior to joining Cowen, he was president of AIG Global Investors with primary responsibility for global asset allocation. He was also president of R.J. Hoffman Co., which served domestic and international clients. In addition, Hoffman has worked as a portfolio manager and research director for Oppheimer Capital Management.
In an interview with reporter Sharon R. King, Hoffman discusses his outlook for U.S. Treasuries and asset allocation strategies for long-term investors.
Q: How long has the bull market been going on?
A: The bull market in bonds can be dated from around 1981, which was the peak in long interest rates for the Treasury bond.
During that time, there was a tremendous controversy, and the bears believed that long rates were going to go to 20% and that inflation was uncontrollable. What happened in essence is that we had entered a period of disinflation.
Disinflation began in earnest with the recession of 1982 and continued on through the Reagan years and up until the current point in time.
It resulted in a reduction in the inflation premium in the market, and it also resulted in a reduction in the risk premium in the market.
During the bear market, you had a negative real interest rate assumption in there.
But bond prices work on nominal rates. And because the nominal rate fell from 15.5% to 7 1/4%, that is the bull market that occurred.
Q: You're forecasting an end to the bull market. What's going to be the impetus?
A: What we think will happen is that with inflation in the very short run at 2% to 3%, the rate of inflation really isn't going to go down very much more, and we'll begin to see evidence that people are tiring of 2% growth.
The reason is that it doesn't create sufficient jobs, and it doesn't create sufficient revenues to contain the budget deficit.
Q: How soon do you expect the end of the bull market?
A: We learned when we forecast the dawn of the new bull market, that the market will respond only very slowly.
The first response will be cyclical.
The longer-term response will probably not begin to occur until it becomes obvious that the fiscal programs that are being proposed now are too small to work in a $6 trillion economy.
And what will be necessary is another wave of fiscal stimulus programs. And at that point in time, I think the bond market will begin to become alarmed.
This is a long-term thing that will probably take, to evolve itself completely, maybe seven to eight years, just like the disinflation case took 10 years to do it.
The significance of my comments are that if you're talking about asset allocation and long-term performance in an asset class, it argues against long bonds as being the long-term winner.
Q: What do you see as the impact on the bond market?
A: First of all, a lowering of German interest rates is a positive for the U.S. bond market.
The reason is that competition by other world instruments has been lessened. There's now the belief that there is going to be a succession of changes that will basically make U.S. bonds relatively more attractive because the dollar may firm during that time, so the total return for a foreigner may improve.
A negative on the same note is the devaluation of the currency raises the price of imports to the U.S. and provides a floor by which U.S. manufacturers can raise prices.
Lower interest rates in the short run caused by this and caused by the low level of growth will eventually cause some economic recovery to occur. Traditionally during economic recoveries, the demand for money will rise.
As the demand for money rises, the fact that the government is so big in the supply and demand equation causes rates to be higher than they otherwise would have been.
Q: What is the alternative to investing in bonds?
A: The alternative is common stocks in the short run or preferred stocks, convertible bonds - something that is more tied to the equity market.
There's a nice part of the yield curve around seven to 10 years which is probably a better alternative than going too far out for those people who want a fixed investment.
For an individual, a staggered strategy is probably the best idea. The staggering should probably go no further out than 10 years, so that some portion of the portfolio is maturing all the time and they can chase the rates up.
Q: Do you recommend a mixed portfolio strategy?
A: Right now, we would only recommend 20% being in bonds and 80% being in stocks. That's a very aggressive stance. The normal allocation stance is a 55% equities to a 45% bonds mix.
Q: Will there be a lot of volatility with the long bond in the next few months because of the political changes?
A: There's a possibility of that, but I think that in reality, the total return just won't be there.
If you start off with a 7 1/4% coupon and you get a backup in the bond market - which I see as a possibility over the next 12 months - I could see it back up to 8%. The total return on the bond basically [would be] zero, because you've lost on the capital side everything you've gained on the coupon side.
During that same time, the equity market could be up as much as 17%, which is quite a big spread. The reason is the market will begin to reflect a cyclical recovery in the economy.
The decline in the German interest rates will probably spark a cyclical recovery in Europe.
The leverage that has been developed by the corporations by the cutting back that took place over the last three years will allow higher profit flow-through to take place. And although interest rates will be rising, which is not unusual during the third leg of a bull market, price-earnings ratios will remain pretty healthy.
Q: Why will the fiscal stimulus package be good for equities?
A: Equities are tied to the economy and to growth. The bond markets typically do better with a very slow growth environment. The risk here is really almost like an alcoholic taking the first drink.
For the last several years, [politicians] have been almost afraid to use a fiscal stimulus package.
But probably within 12 months after the first shot's taken, [economic recovery] will begin to fizzle.
And they'll say, "We had the right formula, it just wasn't big enough. Let's try it again, only this time let's make it bigger."
Q: Since it's going to take a while for the bull market to end, is it too soon for investors to begin switching to a lower allocation of bonds?
A: It depends on what your time horizon is.
If you're a trader, what I say to you is irrelevant. If you own bonds as a trading vehicle, that's one thing.
But if you're owning bonds for the purpose of your retirement nest egg, that's another thing.
The likely direction of short-term interest rates is probably down until the end of the year.
We're talking really to the big, big pension fund manager, the big asset allocator who's setting himself up now and looking for the best total return for the next five years and really thinking of moving huge amounts of money.
Q: Do you get the criticism that this call is too far in advance?
A: We've told you something very significant, and we've taken into consideration the movement in the short run.
For people who are looking to position longer term, the time to really get out is now.
We are about to have a reversal of a trend that has been 10 years in place. That reversal does not take place overnight. The first process of the reversal is a saucer.
We are going to enter that saucer. The length of the saucer before the first major move up is probably going to begin within the next six months.
As we go through the new trend, then people will begin to become discouraged in owning bonds.
Now, you have all the tinder there to explode into another round of inflation, we think that eventually that will be the outcome.