FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 28, 2012

IN THIS ISSUE:

1.  Bonds: The Trend is Your Friend (Until It’s Not)

2.  Reasons Why Bond Rates Could Move Higher

3.  Is the Fed Herding Savers Into Risk Assets? YES

4.  They Don’t Ring a Bell at Market Tops

5.  What is Driving the Stock Markets Higher?

6.  Abbott & Costello on the Unemployment Rate

Bonds: The Trend is Your Friend (Until It’s Not)

I don’t know who first uttered this classic line – The trend is your friend (until it’s not) – but it is timeless. It seems especially appropriate today in light of the massive shift we’ve seen from stocks to bonds since the financial crisis and bear market of 2008-early 2009. Millions of investors have moved from stocks to bonds and consider themselves “safe.”

Today, there are more people invested in US bonds (of all types) than ever before. The degree to which this shift occurred in the last few years is simply stunning. To demonstrate this, let me quote some figures from the Investment Company Institute (ICI) which has long tracked inflows and outflows from US mutual funds.

To the surprise of no one, investors began to flee equity mutual funds in a big way in late 2007- 2008. For the period from 2007-2011, ICI reports that a net total of $408 billion was redeemed from US equity mutual funds – that’s huge! Question is, where did all that money go?

Can you say bonds and bond funds? ICI reports that a net total of (drum roll) $792 billion in new money was invested in US bond funds in 2007-2011. A shift of this magnitude has never happened before. While not all of the equity outflows immediately went into bond funds, this represents a shift of over $1 trillion in five years!

And remember, we’re just talking retail mutual fund investors here – the numbers above do not reflect what large institutional players did with their huge sums of money during the same period. I’ll have more on what institutions have been doing near the end.

For many years, studies have shown that the investment public at large does not make the greatest decisions regarding which asset classes to be in at which times. The Dalbar Studies [Dalbar.com] and others, which I have written about for years, have shown that most investors tend to switch at the wrong times, usually buying high and selling low.

As someone who has often been a market “contrarian,” I look at mass market migrations such as we’ve seen from stocks to bonds over the last four years, and I begin to wonder just what might go wrong with this picture.

The reasons for being invested in US bonds seem to be compelling, right? US interest rates have been falling for 30 years. The Fed promised in 2011 that it would keep short-term interest rates near zero through mid-2013. Then in late January of this year, Bernanke promised to keep short rates near zero until at least mid-2014.

What could possibly cause bond yields to go up, right? So buy more bonds. And investors did just that again in 2011. $136.5 billion flowed into taxable US bond mutual funds in 2011 alone.

US interest rates are at historical lows. Take a look at the 10-year Treasury Note that has traded below 2% for the first time in decades, reaching a record low of 1.695% on September 21 last year.  The 30-Year Treasury bond now yields around 3%, the lowest rate in over 50 years. How much lower do bond investors think rates can go? Remember, bond yields have to go down for returns (prices) to continue to go up.

Reasons Why Bond Rates Could Move Higher

Forgive me for stating the obvious: the US is running trillion-dollar budget deficits and our national debt is exploding. This year, our national debt will exceed our annual GDP. How long will it be before China and other foreign creditors start demanding higher rates to purchase our debt?

I find it very curious that virtually every analyst I read (with the exception of the gloom-and-doomers, of course) believes that the US has at least 3-4-5 years or more before we become Greece. They seem to believe we have that long to get our financial house in order.

First of all, there is no guarantee that we have that long in any scenario. Those suggesting we have 3-5 years to get our house in order must assume that there won’t be another financial crisis or recession in the next several years. I wouldn’t make that bet.

At the risk of criticism from my more liberal readers, I would remind everyone that if President Obama is re-elected in November, it is very unlikely that we will get our deficits under control in the next five years. I should add that the odds don’t increase much if the Republicans win either.

Moving on, inflation as measured by the CPI rose 2.9% in the 12 months ended in January. Fed Chairman Ben Bernanke assures us that the rise in inflation over the last year was a temporary phenomenon, and the Fed has adopted an official inflation “target” of 2% or less going forward. Rising inflation, if it continues, is bearish for bonds.

Next, the US economy is showing more signs of recovery. More and more forecasters think we’ve turned the corner and that growth will improve later this year and next year. I’m still not onboard with this outlook, but if the economy does improve, that will not be bullish for bonds.

Finally, the European debt crisis is far from over. The bailout measures enacted since last summer do NOT solve the problem, and arguably make it even worse long-term. I expect the European debt crisis to be front-and-center again by this summer at the latest. This, once again, will not be good for bonds. I will focus more on Europe in an upcoming E-Letter.

Is the Fed Herding Savers Into Risk Assets?

As we all remember, the Federal Reserve slashed its key short-term Fed Funds rate to near zero in late 2008 in the depth of the financial crisis. The rate has been there ever since. Historically, the Fed Funds rate has been the central bank’s key tool to spur the economy, but it remains to be seen if it works this time around.

In August of last year, the Fed announced that it would keep the Fed Funds rate near zero until mid-2013. Then earlier this year on January 25, Bernanke announced that the rate would be held near zero until at least mid-2014. Wow, they must really be scared!

The fact that short rates will remain near zero for another two years or more is almost a guarantee that returns on risk-free investments will remain next to nothing, as has been the case since late 2008.

So, can a case be made that the Fed is driving investors out of CDs, money market funds and other risk-free or near risk-free instruments? I would have to say the answer is YES. More and more investors, especially retirees on fixed incomes, are moving into higher yielding bonds.

And we’re not talking only about Treasury bonds. Just last week, cable TV network Viacom raised $250 million by selling 30-year bonds at an astoundingly cheap 4.5%. Note that these bonds are not secured, yet they were snapped up at a premium of only 1.5% above Treasury bonds which are guaranteed by the government.

I only hope that investors realize the increased risk they are taking in buying traditional bonds of all stripes at this point.

They Don’t Ring a Bell at Market Tops

I have been in the investment business for almost 35 years. One of the first things I learned way back when is that no one knows in advance when market (or economic) tops or bottoms will occur. We identify those major trend changes only well after they actually happen. As the old saying goes, they “don’t ring a bell.”

Second, we’ve all seen in recent years that markets move with increasingly more volatility, both on the upside and the downside.  Surprises come around more and more often. Increased volatility and surprises are highly correlated with the increase in government debt (maybe I will write more on this subject at a later date).

My point today is that the multi-year bull market in bonds could suddenly come to an end this year. I don’t believe we have 3-5 years to get our financial house in order. For reasons outlined above and others, I fear that the bond market could get hit hard this year.

As always, I could be wrong about the bond bubble bursting this year, but think about it. Do you really believe you are “risk-free” in bonds or bond mutual funds? Do you understand that the longer the maturity your bonds or bond funds have, the higher risk you have? The answers to these questions are critical.

I just don’t want any of my readers to incur big losses this year
if bonds are the next asset class to get hit hard.

Short Commercial: There is one bond manager I recommend above all. The company is Wellesley Investment Advisors. They specialize in “convertible bonds” which most investors know little about, but convertibles can be a great hybrid of bonds and equities.

Wellesley has an outstanding track record. If you haven’t considered Wellesley, and you share my concerns about traditional bonds, you should consider this strategy now. I have my largest personal investment with Wellesley. To learn more about Wellesley, CLICK HERE. (As always, past performance is no guarantee of future results.)

What is Driving the Stock Markets Higher?

Some equity market observers assume that retail investors are the driving force behind the remarkable run-up in stocks since the lows in March of 2009. They would be wrong. As discussed above, retail investors bailed out of stocks and flocked to bonds and bond funds in 2009, 2010 and 2011. Take a look at the following chart from Bloomberg:

The green line in the chart above shows money flowing out of the stock market in “non-block” trades for the period shown. The vast majority of non-block trades are from retail investors. While the chart only shows activity since August 2011, the trend has been virtually the same since 2008. While retail selling did slow down in 2009, it accelerated again in 2010 and 2011.

Also note that the trend in outflows reversed to modest inflows earlier this month. It is impossible to know if this will continue, but with the recent improvement in investor confidence, it would not be surprising. As noted above, retail investors have a history of buying on strength rather than on weakness. Let’s now compare the chart above to what institutional investors have been doing over the same period:

Here we see that institutional investors have been adding money to stocks almost continuously over the period shown. The vast majority of block trades are executed by institutions, and this pattern has been ongoing since 2009.

The conclusions are obvious. Institutions have been adding money to equities since 2009, while retail investors have continued to bail out even as prices rose significantly. One wonders what the markets will do if retail investors decide to come back in a big way. I find that doubtful, however, but you never know.

Abbott & Costello on the Unemployment Rate

COSTELLO: I want to talk about the unemployment rate in America.
ABBOTT: Good Subject. Terrible Times. It's 9%.
COSTELLO: That many people are out of work?
ABBOTT: No, that's 16%.
 
COSTELLO: You just said 9%.
ABBOTT: 9% Unemployed.
COSTELLO: Right 9% out of work.
ABBOTT: No, that's 16%.

COSTELLO: Okay, so it's 16% unemployed.
ABBOTT: No, that's 9%...
COSTELLO: WAIT A MINUTE. Is it 9% or 16%?
ABBOTT: 9% are unemployed. 16% are out of work.

COSTELLO: IF you are out of work you are unemployed.
ABBOTT: No, you can't count the "Out of Work" as the unemployed. You have to look for work to be unemployed.
COSTELLO: BUT THEY ARE OUT OF WORK!!!
ABBOTT: No, you miss my point.
 
COSTELLO: What point?
ABBOTT: Someone who doesn't look for work, can't be counted with those who look for work. It wouldn't be fair.
COSTELLO: To who?
ABBOTT: The unemployed.

COSTELLO: But they are ALL out of work.
ABBOTT: No, the unemployed are actively looking for work. Those who are out of work stopped looking. They gave up. And, if you give up, you are no longer in the ranks of the unemployed.
COSTELLO: So if you're off the unemployment rolls, that would count as less unemployment?
ABBOTT: Unemployment would go down. Absolutely!

COSTELLO: The unemployment rate goes down just because you don't look for work?
ABBOTT: Absolutely it goes down. That's how you get to 9%. Otherwise it would be 16%. You don't want to read about 16% unemployment do ya?
COSTELLO: That would be frightening.
ABBOTT: Absolutely.

COSTELLO: Wait, I got a question for you. That means there are two ways to bring down the unemployment number?
ABBOTT: Two ways is correct.
COSTELLO: Unemployment can go down if someone gets a job?
ABBOTT: Correct.

COSTELLO: And unemployment can also go down if you stop looking for a job?
ABBOTT: Bingo.
COSTELLO: So there are two ways to bring unemployment down, and the easier of the two is to just stop looking for work.
ABBOTT: Now you're thinking like an economist.

COSTELLO: I don't even know what the hell I just said!

And now you know the real reason unemployment figures are improving!

Hoping you’re not overloaded in bonds,

 

Gary D. Halbert

Special Articles

Bell Rings for Bond Bubble
http://www.ibtimes.com/articles/295168/20120208/bell-rings-bond-bubble.htm

Time to Short the Bond Bubble?
http://www.valuewalk.com/2012/02/time-to-short-the-bond-bubble/

Is the bond bubble about to pop?
http://www.marketwatch.com/story/is-the-bond-bubble-about-to-pop-2012-02-24

 

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