Gary Shilling Gary Shilling.

The “bond rally of a lifetime” that he forecast 38 years ago remains intact, but “may draw to a close before long,” writes economist and money manager Gary Shilling in his latest market outlook.

Even then, says Shilling, Treasuries may still be attractive versus stocks on a yield basis. The 30-year Treasury bond, which Shilling favors along with its zero coupon 30-year version, is currently yielding 1.95%, about the same for the S&P 500 index, with far less risk.

Moreover, bond yields could fall further as the recession, which Shilling believes is already underway, deepens, the U.S.-China trade war escalates and “deflation unfolds.”

A decline in the 30-year Treasury yield from 2% to 1% would deliver a 27% total return following an almost equal decline over the past year, as the 30-year bond yield fell from 3% to 2%, hitting Shilling’s forecasted target.

The decline in bond yields during the past year “may not seem like much, but it created a total return of 25.5% for the 30-year coupon bond and 34.5% for the 30-year zero coupon issue,” writes Shilling. In contrast the S&P 500 has gained about 2% over the past year.

Shilling is not forecasting negative yields for U.S. Treasuries, as has been the case with many European government bond issues, but notes that such a development would deliver even greater gains in U.S. Treasuries.

“If a bond has a negative yield of, say 0.5%, it still appreciates if the yield drops to minus 1%.”

Unlike many financial advisors, investors and even fixed income fund managers, Shilling buys bonds for capital appreciation, not income. “We’ve always owned Treasury bonds for appreciation, not yield. We couldn’t care less what the yield is as long as it’s declining and pushing bond prices higher.”

He favors long-term bonds over short- and intermediate-term securities because their price gains are greater when rates fall.

Shilling also favors Treasuries over stocks because Treasuries don’t suffer from irrational exuberance as stocks tend to do and because bonds’ yields (and prices) reflect “well-defined forces” such as Federal Reserve policy and inflation or deflation. Stocks, in contrast, are influenced by multiple factors including the business cycle, industry conditions, legislation, quality of corporate management, merger and acquisition possibilities, corporate accounting, pricing power and more.

In the current economy, stocks will continue to struggle, says Shilling. “The only difference between the long-term growth in the stock market and the economy is the price-earnings ratio …  But for that P/E to return to its long-run average [of 16.9 based on the Shiller cyclically adjusted P/E ratio, or CAPE] would require a 40% drop in average stock prices.”

Shilling is recommending, as he has for months, that investors favor long-term Treasury bonds — “a safe haven in a sea of global trouble” — remain long the dollar, another global safe haven; and favor defensive stocks such as consumer staples, utilities and health care. He’s also recommending that investors short commodities such as copper as the dollar rises and demand weakens due to slower growth in China and elsewhere, and continue to hold “heavy cash positions.”

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