Is there a bond or a stock bubble?

Column by Patricia Kummer

Posted

The financial markets seem to be improving after a very rough decade. Now that the Dow Jones Industrial Average (DJIA) has doubled since the low point in 2007, investors are feeling it is OK to put money in the market.

If you did not panic in 2007 and stayed the course, you are in much better shape than someone who flew to safety and abandoned their growth counterparts. More money flowed into bonds as a flight to quality in 2012 than 2008 and 2004 combined. So while the equities markets were busy doubling, most investors were buying bonds.

Knowing when and where to invest is always a quandary. There is always a justification to do nothing, or “wait it out.” There will always be uncertainty, which is why you can't use the economy or the financial markets as a guideline for investing. You should create your own strategy based on the length of time you have before you need the funds, how much volatility is tolerable and how much diversification is needed. Don't think of one asset class as better than another, or that you should only be in one at a time. The real trick to managing risk is to determine how much and what type of fixed income or equities you should hold and for how long.

Diversification at a minimum should include both fixed-income assets (bonds) and growth assets (equities). Good advisers will drill each of those categories down into specific asset classes, including on the bond side, short, long, government, corporate and foreign. Those can be dissected again into high yield, municipal, emerging or developed markets.

On the equity side there are even more choices, including value, growth, large, mid, small, domestic, developed foreign, emerging markets and alternatives. This last category can be broken down into a myriad of options including real estate and commodities.

Therefore, the over-simplification of bonds versus equities is truly a macro view for this exercise. Here are some signs of a bond bubble:

• The Federal Reserve purchased 75 percent of U.S. government debt in 2012. Eventually the Fed will need to back off the easing and the bond supply will escalate, hence pushing prices down.

• Interest rates are at 200-year lows and bond prices are at all-time highs. In order for a bond to have a gain, interest rates would need to drop lower. Since the Fed cannot go lower than zero percent, their bong buying has created the essence of a negative interest rate. When the Fed stops buying bonds, yields would likely increase, further driving down the value of the bond.

Equities have always appeared to be more volatile and hence are perceived as riskier. While that is true in the short term, the opposite may be true for the long term. If your time horizon is at least one business cycle away (seven to 10 years). Then your loss of purchasing power is your biggest risk, not the near-term fluctuations in the equities market.

Investors should be aware of the herd mentality that often leads significant shifts in where investors go. The majority of new dollars in 2012 were buying bonds at high prices when a better strategy would be to take profits and re-allocate to other categories.

Patricia Kummer has been an independent Certified Financial Planner for 26 years and is president of Kummer Financial Strategies Inc., a Registered Investment Advisor in Highlands Ranch. She welcomes your questions at www.kummerfinancial.com or call the economic hotline at 303-683-5800.Any material discussed is meant for informational purposes only and not a substitute for individual advice. Investing is subject to risks including loss of principal invested. Diversification and rebalancing may or may not produce positive results. A Bond Bubble workshop will be held on 2/22/13.

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