Tuesday, October 30, 2012

Is the Bond Market "Irrationally Exuberant"?

From global equity strategist Michael Hartnett of Merrill Lynch:

The bond bonanza continues. This week's flows show the biggest bond inflows ever ($9.4bn). 

In December 1996, Fed Chairman Alan Greenspan made worldwide headlines by posing the question:  Are stock investors being irrationally exuberant?

The phrase "irrational exuberance" was first coined by Yale professor Robert Shiller, who mentioned it to Greenspan in an early fall meeting in 1996.

Dr. Shiller - who went on to write a book titled by the same name - was was questioning whether investors had bid the prices of stocks far beyond what fundamentals would warrant.

Shiller and Greenspan were eventually proved correct, of course, although the market did not actually begin to start declining until the early part of 2000.

The larger point, however, was that markets are often manic depressive in their actions. One day investors can be wildly over enthusiastic, and push prices to unsustainable levels.  On other days, gloom and doom settles over investors, and prices plummet to levels far lower than economic reality.

It would be hard to suggest that stock investors today are even remotely "exuberant".  Outflows from domestic equity funds have been almost constant for the past five years, and it is hard to pick up any investment or business publication without reading about some calamity that is about to occur.

In the bond market, however, it is a much different story.

Bond investors continue to gobble up fixed income investments of all different types.  For five straight years, individual investors have been fleeing the domestic stock market, mostly in favor of bonds.

However, with interest rates at historic lows, many are questioning what will happen when interest rates eventually begin to rise.

My feeling is that the most vulnerable group will be those that are moving in the bond mutual funds.

If you buy an individual bond with a stated final maturity, you at least have the comfort of knowing that you will eventually get your principal back, regardless of the future direction of interest rates.

Investors in bond mutual funds, however, have no such certainty.  Managers of bond mutual funds typically keep their interest rate exposure within a certain range, which in effect means that investors in bond funds lose the attractive feature of getting their money back at some point.

Put another way:  it is very possible to suffer a permanent loss of  principal by investing in a bond fund, even though bonds are typically considered "safe".

Writing on his blog The Reformed Broker, investment advisor Joshua Brown wrote a searing column on the fate that will eventually befall those that are plowing hard-earned investment assets into bond mutual funds at today's low yields:

There's going to be such a brutal bond investor slaughter at some point over the next decade that the streets of Boston's mutual fund district will run red with blood, the skies will be shot through with the lightning and thunder of unexpected capital losses and those who manage to survive will envy the dead....

And it will come.

You know how I know this? Because you lunatics are plowing money into fixed income at all-time low interest rates during the parabolic final phase of a 30-year bond market rally. You are going limit-up long into one of the most obvious blow-off tops in the history of investing. And you're doing this with almost guaranteed inflation ahead of us and only the prospects of negative real rates of return on your T-bills.