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Despite the robust stock market rally from the March 9th lows, most investors have been enamored with what they perceive to be “safe” investment alternatives in today’s economy and market environment. Bonds and gold, therefore, have become the investments du jour while stocks have largely been ignored.
Morningstar reports that, year-to-date through September, investors have made net contributions of over $197 billion into taxable bond funds and almost $57 billion into municipal bond funds. U.S. stock funds, on the other hand, have attracted net inflows of less than $4 billion and international stock mutual funds have seen net contributions of less than $11 billion. In other words, for every dollar investors put in stock funds, they placed nearly seventeen dollars into mutual funds that invest in bonds. But, we advise caution to bond fund investors for several reasons.
Keep in mind the inverse relationship between interest rates and bond prices. As interest rates rise, bond prices typically fall, and vice versa. For example, if you purchase a Treasury bill today with a 3% yield and, subsequently, similar Treasury bills are paying 4%, the market price of your original bond will drop. The price declines in order to compensate a potential purchaser of the original bond for the lower income stream. The same phenomenon occurs with mutual funds that invest in bonds. If interest rates rise, the bonds held by the mutual fund would likely lose value, causing the fund net asset value to suffer.
When using a mutual fund to gain exposure to bonds, the decisions of other fund shareholders can also have a detrimental impact on returns. For example, when interest rates creep upward and the bonds held by a mutual fund begin to lose value, bond fund shareholders will probably begin withdrawing their money. (As we have seen time and time again, individual investors generally chase performance.) This leaves the fund managers without fresh cash to purchase new bonds at higher rates, further compounding an already difficult situation.
It can also be dangerous to base investment decisions on a past trend. The preceding 27 years have seen a secular bull market for bonds thanks to a declining interest rate environment. In 1982, the U.S. fed funds rate reached 20% to battle runaway inflation. Since then, interest rates have declined rather steadily and with few interruptions to a current fed funds target rate of zero. Clearly, policy makers cannot force interest rates any lower. And if the global economy continues to show signs of improvement, then central banks will likely raise rates to curb the inflation threat that the market perceives in loose fiscal and monetary policy.
Beyond the bond market, gold has been another hot asset class in 2009. According to Fortune, the SPDR Gold Trust (GLD), the world’s largest gold exchange traded fund, has drawn over $12 billion in net assets this year. Amazingly, this fund alone has attracted roughly three times the total net assets that all U.S. stock mutual funds collected through the first nine months of the year. Even 1990s rap music sensation MC Hammer has gotten into the mix, touting “Cash 4 Gold” in one of numerous television commercials that gold recycling companies are running to cash in on the fever.
During the past decade, the spot price of the “yellow metal” has climbed from under $300 per ounce to over $1,000 today. But, it is difficult to gauge the intrinsic value of an ounce of gold because it does not produce a profit, pay a dividend, or create value in any real way. As Warren Buffet once quipped, “[Gold] gets dug out of the ground . . . Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
These money flow statistics are instructive, not because they offer any real clues to the upcoming short-term trajectory of stocks, bonds, or gold, but because they reveal that investors appear to be succumbing to fear, perhaps at the expense of investment discipline.
One of the simplest and most effective investment strategies is to periodically rebalance a portfolio. While it can sometimes require intestinal fortitude, systematic rebalancing serves to increase exposure to “riskier” securities following big losses and helps investors buy low and sell high; the ultimate goal of investing. If investors were rebalancing, one would expect to have seen more money flowing into stock funds this year. Instead, dollars are continuing to favor safe haven investments while many investors have already missed a healthy and rapid rally in stocks.
Any experienced investor has undoubtedly felt the temptation to stray from a disciplined investment policy. But, in the words of Hindu Prince Siddhartha Gautama, better known as Buddha, “Endurance is one of the most difficult disciplines, but it is to the one who endures that the final victory comes.”
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