Very Different Assets, the Russell 2000 and Muni Bonds, Both Look Overvalued

Things have come to a pretty pass.  The romances are going flat…

Let’s start with munis.  It’s pretty simple.  Two Septembers ago, I wrote a post titled Gold on Hold; The New Play May Be in Munis.  This was done in the context of recession worries, and was in the context of a well-documented and major shift I had made and wrote about in the spring and early summer from risk-on assets to the twin risk-off assets of gold and Treasurys.  Munis yielded more than Treasurys and since that date, a muni bond fund such as NIO has done great, even compared to stocks; and, much more cash has actually been put in investors’ pockets rather than simply a high trading price that stocks have.  Trading prices, as we have  learned, can change rapidly and drastically against one with no warning.

Over the past 12 months, munis have finally normalized against T-bonds, and then some.  The results are astonishing.  Per Bloomberg data, the 30-year muni bond (a rare bird, and rarely non-callable, so I don’t know what index they are using or what credit quality their reference bonds have) has fallen a massive 71 basis points to a yield of 2.84%.  The 30-year T-bond has only dropped 2 basis points to 3.13%.  This puts the muni yield back to its historical relationship to Treasurys.  A long-term muni buyer at that yield has all sorts of issues involving credit, liquidity, interest rate risk and tax risks.  The 10-year muni has dropped 24 bps to 1.68% while the 10-year T-note has dropped 5 bps to 1.95%.  The tax-exempt bond fund MUB has a yield to maturity of about 1.55% after expenses for a duration of 6 years, and while I haven’t contacted the iShares people, yield to maturity for bonds trading above par should be a good deal higher than the yield to call.  

Seeing this, I actually was able to sell some zero-coupon long-term muni bonds (retail pricing) yesterday for the first time not to raise cash but to simply lower my exposure.  It is nice to receive a decent income from a bond and then sell it for a long-term capital gain.

Right now, many bond investors may want to reconsider the advantages of Treasurys over munis, which look fully priced and then some.

Similarly, the Russell 2000 is close to leaving earth orbit and heading into outer space in its valuation.  The iShares tracking ETF for this index, IWM (LINK) has a bubble-era P/E and only a slightly less bubbly price to book.  The listed trailing P/E is 25.4, but this understates it an unknown amount.  First, the iShares people ignore losses, which are common in this part of the market.  They do not measure aggregate profits of their 2000 companies (if they track all 2000 members of the R2K) and then measure the P/E.  Instead, they fudge and make the aggregate P/E lower by simply only measuring the P/E of the profitable companies.  Second, they round all P/E’s above 60 down to 60.  (And there are several of them, to be sure.)  

The Russell 2000 now has a much higher P/E even than established growth companies such as GOOG and AAPL.  

We now have a first in my experience.  The traditional default safe haven for middle-to-upper middle class wage earners and for the wealthy, muni bonds, are risky in various ways.  So is the equivalent of the NASDAQ of 15 years ago, the Russell 2000.

It is a new ballgame both for value and for income investors.

(To be continued.)


4 comments to Very Different Assets, the Russell 2000 and Muni Bonds, Both Look Overvalued

  • Bobby

    Wonder if now is a perfect Short the Russel play

    • dd

      Bobby, there is no perfect short, but if you have exposure to small caps or small cap stock funds already, i think now is not a bad time to “lay the points” and set up a small short with lots of optionality. otherwise, Doc is wise and makes a good point.

      i’m not in the business of giving advice, but i will say, with a fair amount of experience: there are few times when you see an index priced this high, while there are individual stocks and value funds within that very same index out there sitting on ridiculously cheap stuff.

      there is opportunity out there on both sides of the ledger like i haven’t seen in a long time. you don’t get many shots at this kind of environment, once very 5-10 years. for what it’s worth …

  • Bobby- I don’t think so. Shorting the Russell when QE is just ramping up is a risky proposition. It is also fighting the Fed. Overvalued markets rarely fall simply for that fact. Think of the history of the NASDAQ in the second half of the 1990s. Jim Grant wrote a book describing the NAZ as seriously frothy and overvalued– in 1996! He was correct- but was only 4 years early…

    FWIW, my view re seriously overvalued markets is like the old song: walk on by. Ignore them. Almost always, every major overvalued market sector has a corresponding relatively undervalued sector.