Only Twice in US Financial History

Only Twice in US Financial History

Halley’s Comet visits earth every 76 years. For the average person, this is a once in a life time event. Right now there is an event in the financial world that hasn’t happened since 1861 just over 150 years ago. In 2011, we completed a thirty year period in which bonds outperformed stocks. This is an anomaly so rare that it hasn’t happened since 1861. I would submit that it probably won’t happen again in your lifetime perhaps even your great-grandchildren’s lifetimes.

The public response to this has been wrongly thinking, “Bonds seem safe and do better than stocks so why take the risk?” The result is that money has been pouring into bonds at unprecedented rates. Also, that many companies, which are experiencing record earnings and have never been more profitable and flush with cash are being passed over and ignored by investors. When has John Q Public ever been right?

Often people choose investments based on what seems like is doing well. What is happening right now is that the masses are pouring into bonds which are pushing prices higher and higher and yields lower and lower. This trend has gone on far longer than anyone would have guessed, but it will eventually get to a point where yields will get so low that they literally can’t get any lower. At that point, I imagine you’ll start to see a very ugly correction to this once in 150 year anomaly and prices will rise sharply as we return to normal.

The strange thing right now is that yields on most bonds (and there are a few, very few exceptions to this situation) are so low that people are buying bonds that return almost nothing, but are loaded with price risk not seen in our lifetimes perhaps even since 1861. The great investors Shelby Cullom Davis said, “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” The yields are so low, that a bump back to normal could cause prices to shock out years of low yields for investors.

Again, this 30 year bull market in bonds has gone on longer than anyone could have guessed and may go on longer that I would guess, but it is inevitable that at some point it will reverse direction. And more to the point, there isn’t a lot of room left for it to keep going this direction. And even more to the point, there isn’t a lot of reason to hang around in bonds to see how much more you can squeeze out of it.

What could trigger rates to back up? Here are some possibilities:

1) The Federal Reserve backs off its easing efforts

2) Inflation goes up

3) The economy improves, loan demand goes up as consumers and businesses start lending

4) Investors feel better about stocks and shift money from bonds (very imaginable as there isn’t much to give up in terms of yield in bonds)

Any of these could trigger it, but I believe that a quick and sudden slide in bond prices could start an avalanche of selling, further exacerbating the price drop. It is simply what historically happens at the end of a bull cycle.

I talk a lot about bonds and help people understand what causes their prices to go up and down. Part of it is that I don’t believe that people always understand what they are invested in. I believe that an educated investor should be able to see that bonds are in a potentially dangerous place right now and look at other options before everyone else does. In my opinion, the most dangerous thing that investors can do right now is to be indecisive and let time tick along month after month.

This is not to say that there is no place for bonds, but that investors need to be aware of where we are right now. There are certain kinds of bonds posing more risk than others. The investors with the most risk may be those who have completely capitulated out of stocks and into bonds. I fear this group will get burned again and in a place they assumed to be safe.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Bonds are represented by the Barclays Capital Aggregate Bond Index and stocks are represented by the S&P 500. Investing in securities, including stock and bonds, is subject to market fluctuation and possible loss of principle. No strategy can assure success or protect against loss.