Economic Perspective – Market Volatility & Bonds – July 1, 2010
by J. David Lewis
When we published “Is the Recovery for Real?” – More than Money Resource, June 1, 2010, there was not room to develop another concept, which still deserves attention. In the words of Dirk Hofschire, CFA®, writing for Fidelity Management & Research Company’s Market Analysis, Research & Education (“Stock Market Corrections: Unsettling But Not Unusual,” May 2010). “With U.S. stocks falling more than 10% from their April peak, the market has officially entered correction territory for the first time since the cyclical bull market began in March 2009.”
We have heard and felt tension with people who focus on day-to-day markets. Some pay more attention to the “up days,” while others focus on the “down days.” After the trauma of the last 18 to 24 months, the discomfort is understandable. There is considerable evidence people are looking for safety. On Tuesday, June 29, my Wall Street Journal email titled “The Evening Wrap” reads; “The concerns sent investors fleeing to safety assets, sending the dollar, gold and Treasurys higher. The rise in Treasurys pushed the yield on the 10-year note below 3%, to its lowest level in more than a year. Bond yields move inversely to prices.” Now, I want to explore whether bonds will help. I hope to also discuss my thoughts on the role of annuities soon.
Bonds seem much safer than stocks for most people. The economic trauma is still fresh enough for today’s extremely low interest rates to seem acceptable for perceived safety. Yet, we are seeing quite a few articles warning investor of bonds’ interest rate risks.
The bold front page of American Association of Individual Investors Journal (June, 2010) reads “Bonds and Interest Rate Risk.” The article begins with “Recent cash flows into bond mutual funds and exchange-traded funds have been very strong.” The article has considerable detail on how rising interest rates decimate bond prices, especially for bonds with long term maturities.
Morningstar Advisor, a sophisticated publication for independent advisors, has a June cover that reads “Bond Fire – Ignoring the dangers, investors rush to fixed-income funds.” An article titled “The Game Is Up,” discusses the dilemmas facing bond mutual fund managers as more money flows in. With interest rates low, they cannot provide the income investors want. When interest rates eventually increase bond values will fall, along with the value of the mutual fund shares. There is a very high probability fund managers face a “no-win game,” trying to navigate portfolios through these perils. Bond funds typically do not close to new inverstor when the managers believe the markets are poor for their particular expertise.
These and other commentaries seemed to set the stage for an NPR comment near mid-June. I didn’t catch the program, interviewer or interviewees’ names. The program was similar to much of the background information in my life, until a line to the effect “the definition of a bubble is whatever has exceptional flows of cash until it burst.” After that, I again heard a version of the story about exceptionally high investment flows to bonds and the interest rate risks these investors are taking.
One of my all time favorite investment stories began in May 1978. I was probably one of the youngest attendees at The American Bankers Association – National School of Bank Investments. These bankers were passionate about bonds for the seven-day school. The last event was a panel discussion that resembled a debate over whether interest rates would peak in October or December. Most of us there did not believe the U.S. economy could sustain interest rates higher than they were already. If these panelists were right, our stress would soon finally end. They professed that interest rates were destined to stabilize or fall in a few months, which would mean relief from our fears of continued rising interest rates and falling bond prices.
I recently added the red vertical line to this graph, borrowed from Chris Davis’ “Is the Recovery for Real?” presentation. It marks the approximate date of my 1978 story. The gold line represents the continued unexpected climbing interest rates. The orange line represents bond prices that continued to fall for at least three years.
The very important lesson I learned was that these “experts” completely missed it very badly. Today, cash flows into bond mutual funds tell us that many people are buying into much more bond risk than they imagine. The most likely reasons are the trauma of 2008 and the recent volatility. They are motivated by a belief that they are being safer than they would be with stocks. The title of the graph is “The Last Time Yields Were This Low, Bond Prices Plummeted for Over Two Decades.”
Now, let’s put the recent volatility into perspective by returning to the Fidelity commentary. This time, the correction occurred about 14 months after the current bull market began. Typically, bull markets have a correction around 17 months after they begin. This time, the market gained 80% before the first correction. The typical gain is 57%. The significant difference for this correction, compared to typical corrections, is the number of days to fall 10%. This time it was 27 days, which is about half the historically typical 54 days. With the last few years as a background, it is easy to understand some of the motivation to follow the crowd into bonds. We think bonds are probably more dangerous than most people realize.
Quoting directly from the Fidelity piece – “Since 1926, there have been 20 stock market corrections during bull markets, meaning 20 times the market declined 10% but did not subsequently fall into bear market territory. Whether the market recovers again from here and avoids a bear market remains to be seen, but at the very least the more surprising development based on historical patterns would have been a continued bull market rally without a 10% pause.”
Since the Fidelity piece was published, there have been several days that were dramatically up or down. As this is written, we are only about 60 days after the peak before our current volatility began. In the scheme of things, taking a week at a time, there has been little meaningful change since mid-May. We expect to continue with the portfolio philosophy that has served our clients and us well for twenty-five years.
J. David Lewis founded Resource Advisory Services in 1985. National Association of Personal Financial Advisors (NAPFA) was formed only a few years before. Lewis became a NAPFA-Registered Financial Advisor in 1986. He is a passionate advocate for fiduciary, fee-only financial planning and has been associated with financial services since childhood in a banking family. Contact him using firstname.lastname@example.org.