More On Treasuries

This was published last week @ Barrons on line. I've exerpted it here and will provide a link after the article. It makes my arguement about Treasuries but in a more understandable manner.

HULBERT ON MARKETS

Stay Away From Long-Term Treasuries
By MARK HULBERT

"The quintessentially safe U.S. investment is overpriced and won't outpace inflation. Consider an inflation-protected alternative.

IT'S ALWAYS DANGEROUS TO THINK that we know more than the market. One doesn't have to be a fanatical believer in the markets' efficiency to nevertheless recognize that markets reflect a lot more information than any one of us can possibly incorporate into our analysis. The graveyards on Wall Street are filled with those who had the arrogance to believe otherwise.
So it is with no small dose of trepidation that I explore the possibility that U.S. Treasuries are incredibly overpriced, which of course is just another way of saying that their yields are way too low. But if they are, then investors should run, not walk, away from placing any long-term bets in U.S. Treasuries.

Instead, consider the alternative investments that I describe below.

Right now the yield on the 10-year Treasury note stands at 2.89%. On an after-tax basis for an investor in the highest tax bracket, that translates into an effective yield of 1.88%. In order for such an investor to show any real (after-inflation) return over the next 10 years, inflation therefore would have to average less than 1.88% for the next decade.
What are the chances of that? Even if you are investing in a tax-free account, what are the odds that inflation for the next decade will average less than 2.89%?

While you're mulling over your answer to these questions, consider the following: In July 2007, the 10-year Treasury note was yielding 5.2%. In other words, despite the federal government injecting trillions of new dollars into the financial system over the last 18 months, in a textbook illustration of the monetary inflation for which Federal Reserve Chairman Ben Bernanke earned his nickname of "Helicopter Ben," the markets are nevertheless discounting a much lower inflation rate today than then.

Or consider this mathematical truth about the power of compounding. Let's assume that the inflation is negative for the next two years, at a rate of (negative) 2% a year. That's deflation, in other words. That's a big assumption, since Helicopter Ben has dedicated himself to never allow the economy to slip into deflation.

But let's nevertheless assume that we get a 2% deflation for each of the next two years. Let's further assume that for the eight years thereafter that consumer prices actually grow and the inflation rate is 5% a year. That seems reasonable given how much money would be injected into the economy if we actually get a sustained deflation -- money that presumably will eventually translate into higher inflation. Given these assumptions, the inflation rate over the next 10 years will still average 3.6% a year. That's more or less twice the 1.88% after-tax current yield of the 10-year Treasury note.

To be sure, we can endlessly play around with these assumptions. But the general idea is clear: Locking in Treasuries' current yields provides a long-term real return only if inflation is a whole lot lower than what it seems quite clear it will be.
How did the markets get into this situation? The obvious answer: panicked investors' flight to quality over the last 18 months. Investors have been so concerned about the credit quality of any borrower other than Uncle Sam that they have been willing to forfeit much, if not all, of their yield. It's not that investors during this flight to quality reduced their expectations of future inflation. It's instead that in their panic they became preoccupied with the safety of their principal. Unless the world comes to an end, however, this credit and liquidity crisis won't last forever. And when it does dissipate, Treasury yields will once again reflect investors' expectations of future inflation. You don't have to be a market timer and try to predict when this will begin to happen to know that -- absent the end of the world -- it will take place eventually.

In many ways, the current situation is just the inverse of what prevailed in 1981, when the yield on the 10-year Treasury climbed above the 15% level. That meant that investors were betting that average inflation for the subsequent decade would be close to double digits. That in effect meant that investors were betting on the financial equivalent of the end of the world, since double-digit inflation for 10 years in a row would have been nothing short of devastating.
It took courage at that time to follow the contrarian conclusion and buy Treasuries. But there were at least some who did: The editor of one of the investment newsletters I monitor, who asked that I not use his name, told me that he put his daughter through Yale on the profits he earned from buying Treasuries at that time. And, it's probably needless to say, Yale's tuition is not cheap."

Hulbert then lists some ETF's that might be profitable if what he describes comes to pass. They are Barclays 10-20 Year Treasury Bond Fund (ticker: TLH), TIPS- the Treasury securities that are indexed against the consumer-price index and which therefore provide a guaranteed return above and beyond inflation and an ETF that invests in TIPS, the iShares Barclays TIPS Bond Fund (TIP).
Here is a link to the article. A subscription may be required. http://online.barrons.com/article/SB123377146295048587.html.