The divergence of short-term and long-term perspectives

October 13, 2023

By this point in 2023 you may have noticed that both the stock and bond markets seem decoupled from the news. You hear good economic news, and the bond market goes down. Sometimes the stock market goes up, sometimes it goes down. A war starts and the stock and bond markets rise. If you're confused, and wondering if it's you, it's not.

The amount of debt and leverage in the U.S. and around the world, has increased steadily over the past twenty years. Reliance on debt has made the Fed a larger player in the economy, to the point that high schoolers know the name of the Fed chairman. The economy may say one thing, but its implications on future Fed actions may argue the opposite. And markets have to choose their dominant signal on a given day.

To make matters more difficult, historical macroeconomic models are not working well.

I need to correct one common misconception. People assume they are making 4% - 5.5% in bank savings accounts, CDs, and short-term Treasury bills. With rare exception, where these are held in retirement accounts, they are not. This interest is taxable and the after-tax rate they are making is in the 2.5% to 3.5% range. This is a more accurate return number.

They feel good in these products, but they shouldn't. They have opted for a terrible investment medium to long term, one that even in the short term, due to its tax inefficiency, is producing negative real returns. While we can't know the future, I expect there will be a lot of regret and market-chasing five years from now as people try to reverse this strategy at just the wrong time.

Outside a small group of investing nerds, almost no one has heard of Seth Klarman, a Boston-based hedge fund manager and arguably one of the best investors of all time. He likes it that way. Fourteen years ago I managed to get my hands, or eyes, on a PDF of a book he wrote, Margin of Safety. This book currently sells for $3,780 on Amazon, given that Klarman doesn't want it back in print.

Klarman is a value investor who focuses on buying things on the cheap. He is one of few professional investors who reportedly does not use a Bloombeg terminal, as he does not care about short-term price fluctuations.

In his book, he says:

Consider the example of a five-year 10 percent bond paying interest semiannually which is purchased at par ($100). Assuming that interest rates remain unchanged over the life of the bond, interest coupons can also be invested at 10 percent, resulting in an annual rate of return of 10 percent for that bond. If immediately after the bond is purchased, interest rates decline to 5 percent, the bond will initially rise to $121.88 from $100. The bond rises in price to reflect the present value of 10 percent interest coupons discounted at a 5 percent interest rate over five years. The bond could be sold for a profit of nearly 22 percent. However, if the investor decides to hold the bond to maturity, the annualized return will be only 9.10 percent. This is less than in the flat interest case because the interest coupons are reinvested at 5 percent, not 10 percent. Despite the potential short-term profit from a decline in interest rates, the return to the investor who holds on to the bonds is actually reduced.

Similarly, if interest rates rise to 15 percent immediately after purchase, the investor is faced with a market decline from par to $82.84, a 17 percent loss. The total return, if he holds the bond for 5 years, is increased, however, to 10.99 percent as coupons are reinvested at 15 percent.

Notice that the short-term and long-term perspectives here are quite different. Assuming no default or pre-payment risk, the investor knows the bond is going to pay back its value, at par. And in the meantime, it's better for the bond to decline so the investor can buy more. But it doesn't feel that way in the short term.

While markets don't have guaranteed payback endpoints, this is a powerful idea. We believe it becomes even more powerful as it is implemented across asset classes.

Dan Cunningham