So, are we in a bond bubble? My short answer is that no, we’re not. But there’s a long answer, too. Sorry.
Over $500 billion has flowed into the bond market during the past three years, an orgy of buying similar to the frenzy that Pets.com exploited to become a famous (infamous?) Super Bowl advertiser on the backs of its IPO stock investors. However, the credit market, broadly defined, is about five times larger than the stock market, so asset prices aren’t moving as much. Moreover, the tech bubble was confined to fewer sectors; the impact on stock prices in those sectors was magnified even more.
The nature of buyers is also quite different. Rather than being fueled by greed, the money rushing into the bond arena is afraid of risk and reaching for yield. In fact, by some measures bond valuations are fairly reasonable – within sight of “normal.” Ten year bond yields historically sell around 3 percent above the level of inflation. With inflation practically non-existent, today’s 2.39% treasury yield actually seems fairly rational. Given this deflationary environment, even if bonds are overpriced a bit, the downside wouldn’t appear to be that bad. Nothing like the tech bubble, where many stocks went to $0 and the NASDAQ index still sells 50 percent below its peak, more than a decade later.
So am I saying investors should buy bonds? Definitely not. I believe that bond investors should keep their maturities short, so that when rates go up they can reinvest at higher yields. For bond owners, one of the worst things that could happen is a return to “normalization.” Fortunately, this possibility is on the radar! For bond holders to come out whole, things need to keep getting worse. That is not what anyone wants!
I am saying that investors need to keep “fear” on a short leash, including fear of a bond bubble. Studies prove that investors systematically exaggerate the probability of unlikely events. I may have fallen prey to that tendency this year. My fears of an interest rate surge and currency crisis caused me to underestimate the current recovery in the business sector. I’m not giving an “all clear” signal, but neither am I forgetting that investors’ “worst case” fears rarely come to pass.
The stock market rally is a positive signal. Hiring has turned up, though not to the degree that it normally would. Large companies have access to cheap bond money and rather than running scared, they are using it to buy back stock and grow by acquiring the undervalued shares of other companies. In fact, the longer things appear to be returning to normal, the more likely that they will return to normal.
Don’t let fears of a bond bubble prevent you from making money in the stock market, while we have a chance. I still expect that we’re in a trading range, rather than a new bull market, but in either case it’s important to make money while things are going up. Profits are hard to come by. As of the end of trading on October 11, our fund model is up +8.6% year-to-date and the individual stock model is up +9.7% YTD. It would take government bond buyers about six years, until 2016, to earn what stock investors have made in the first ten months of 2010.
The broad market has climbed +6.2% during this same time, despite strife in Washington, banks clinging tight to what used to be taxpayer money, and savers suffering from an interest rate experiment that is no less than punitive (even confiscatory) as Washington looks to fund its latest vote-getting schemes.
Imagine what return investors might get if we actually got our act together!
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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