There’s no doubt the word “bubble” gets more attention now than it did in better economic days. And the financial press has a vested interest in reporting on attention-getting topics—so warnings of bubbles are best taken with a grain of salt. But there’s one market today where there are certainly a lot of very bubbly-looking things going on, and that’s the bond market. The signals are significant enough to have warranted commentary from an overwhelming number of our contributors, so they may be worth considering. They’re certainly at least worth reading, so a selection is below. First, Tom McClellan, one of Timer Digest’s Top Ten Timers and editor of The McClellan Market Report...
“Back in 2008, one of the reasons why crude oil prices jumped up to $145/ barrel, and commodity prices zoomed up to extreme levels in sympathy, was that portfolio managers were chasing performance. They had gotten used to chasing stock prices up through the top in 2007, but that seemed like a passé idea so they all piled into commodities because commodities were still in an uptrend. The piling in all at once caused oil prices to blow off and collapse, helping to usher in the tough economic situation we face right now. We are seeing the same sort of behavior again right now, except that the recipient of all the piling in is T-Bonds. Bond prices are going up because people are buying into them, and they are buying into them because they are going up.
“Circular logic is not forbidden on Wall Street, but it has limits for how long it can persist. The [chart below] takes a really long look at T-Bond futures prices, going all the way back to 1980. There has been a dominant rising bottoms line that has contained every decline, with just a couple of brief penetrations. If you take a straight edge and lay it above and parallel to that uptrend line, you can see that bond price rallies tend to top out when prices get too far extended above that line. The bond price peaks in 1980, 1986, and 2008 define the real extremes for how far away from the uptrend line bond prices can go. The current level is not quite that extended, but similar degrees of extension above the uptrend line have been enough to halt uptrends in the past, and send bond prices back down to revisit the uptrend line.”
Tom McClellan, The McClellan Market Report
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“Everyone, it seems, is buying U.S. government bonds for one reason or another. The Fed is buying bonds. Retail investors are buying bonds; $340 billion flowed into bond funds over the past year and a half. Central banks around the world are buying bonds, although China has cut down a bit. The Japanese keep buying bonds. Fund managers are buying bonds, too. I know the risks in the global economy are big and plentiful right now. But there’s never been a time when all investors have been in the same trade and that trade has performed to expectations. In the U.S., for example, bonds have outperformed, though not spectacularly, and stocks are still up comfortably on a yearly basis. Keep your bond holdings as a long-term hedge to your portfolio, but keep your allocation to a manageable level.”
Yiannis G. Mostrous, Silk Road Investor
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“Income-hungry investors have spoken, and they have chosen bonds as their investment of choice. In 2009, a record $375 billion of new money flooded into bond funds. Over the same period, domestic stock funds saw $40 billion go out the door. And through the first half of 2010, taxable bond funds had net new cash flow of $136 billion versus outflows of $18.4 billion for domestic stock funds. This torrent of money has driven down the yields on bonds to microscopic levels. Indeed, the yield on the 10-year Treasury is now about 2.6%, and the yield on 3-year Treasury bonds is under 1%.
“For some perspective on just how low interest rates have fallen, the current yield on the Dow Jones Industrial Average of 2.8% is above the rate on 10-year Treasuries. We saw this happen in late 2008/early 2009, just prior to the huge market rally in 2009. Before that, you have to go back to the late 1950s to find a time when the Dow’s yield exceeded the interest rate on the 10-year Treasury.
“The upshot is that, on a relative basis, dividend-paying stocks seem quite cheap compared to bonds. To be sure, the key word here is ‘relative.’ Just because dividend- paying stocks seem cheap compared to bonds doesn’t mean that stocks have to skyrocket. Nevertheless, an important task of an investor is to find asset classes offering relative value, and there’s little doubt that high- quality, dividend-paying stocks are offering some of the best investment values at this time. ... Of course, stocks, even quality stocks that reside in the Dow, typically have a higher risk profile than bonds, which is a major reason investors are shying away from stocks in favor of bonds. However, this risk aversion seems overdone, in my opinion. Indeed, I think investors are overstating the long-term risk of stocks, unfairly extrapolating equity returns of the last 10 years long into the future. And I believe investors are understating the risks of owning bonds. Even a small jump in interest rates would drive bond values down, canceling out several years of interest payments. The bottom line is that income investors who are focused exclusively on bonds should broaden their opportunity set by considering shares of high-quality, dividend-paying stocks from the Dow.”
Charles B. Carlson, CFA, Drip Investor
