Bond Lemmings are Heading for the Cliff
1. (Life Sciences & Allied Applications / Animals) any of various volelike rodents of the genus Lemmus and related genera, of northern and arctic regions of Europe, Asia, and North America: family Cricetidae. The Scandinavian variety, Lemmus lemmus, migrates periodically when its population reaches a peak
2. a member of any large group following an unthinking course towards mass destruction”
On August 21, 2010, the New York Times ran a front page article entitled In Striking Shift, Small Investors Flee Stock Market. The article drew attention to the vast sums of money being shifted away from equities toward bond investments. Just as Americans are adjusting to the somehow radical new fangled idea that a house is really just a home, they are beginning to question the idea that all asset classes are winners as investments. Two years ago I had a conversation with a client who had put money into antiques over a period of years. When he found himself unemployed some while back and wanted to monetize some of them he said: “I learned quickly that they are antiques when you buy them but nothing more than old furniture when you go to sell them.”
In reality, most asset classes have declined by 30% since the collapse of Lehman Bros. two years ago this month. The stock market, real estate, and the art market are all off by about a third. It really didn’t matter how you thought you were diversifying your assets. Many of them are down just about the same amount. In response to that, people have been conditioned to focus more on what they can lose when they make investments than about how much they can make. Clearly, Fear has supplanted Greed as the primary motivator.
Mohamed El Erian was on Bloomberg this past week talking about why people like bonds now. No matter that Mr. El Erian has been mostly wrong most of the time for the last year or two. He is articulate and gets lots of air time as a public spokesman for PIMCO, one of the largest bond managers in the nation. Of course, he has a major axe to grind in this conversation and encourages people to continue to buy bonds whenever he can.
In El Erian’s view, investors are flocking to bonds because they lost so much money in the stock market that they are seeking a safe haven. Fear reigns supreme. Speaking last week on Bloomberg radio he said it isn’t all about “return on your money. Now it is about return of your money.” Sounds cute and worth repeating on air all the time when you manage billions and billions in bonds.
However, this sounds to us a lot like the equity folks in the late 1990’s who had everyone convinced on the other side of the argument. Then, no matter how little money you had to invest, you needed to own Tech Stocks. Everyone was doing it and, just like the tulip bubble centuries before, you needed to get with the program and play the game or be left out. Greed was the primary motivator then.
We have gone back to study the flow of funds into mutual funds in that Tech bubble period to see what exactly was going on in the late 1990’s. History shows that at its peak in the first quarter of 2000, just as the New Millennium was getting underway, people couldn’t rush into the NASDAQ stocks fast enough. Companies with no earnings and not much history of being in business became moon shots as investments, or more properly speculations. In 1999, the NASDAQ index rose from 2500 to about 4000, roughly a gain of 60%. It quickly rose another 25% in the first weeks of 2000. As 2000 began, $251 billion flowed into stocks to enjoy the party. Those who had missed out in 1999 rushed onto that train to nowhere with very bad results. The NASDAQ peaked in March 2000 at 5200 just before it lurched as low as 1200 two years later. The public wanted in just as the game was ending. They arrived just in time to be crushed. That’s why the decade from 2000 to 2009 was so dismal for stock investing. Most of the money was lost right at the outset of the decade and when things started to recover, equity investors were hit with the collapse of the housing bubble. You needed to buy a new house right then while you could still afford it!
Everybody was on a leverage bender. Individuals were tapping their homes for liquidity. The brokerage firms were playing fast and loose on their trading desks with unconscionable leverage of the firm’s capital. That is why Bear Stearns and Lehman vanished. Merrill Lynch was going the same route when Bank of America took it over. The near collapse of the global financial system scared everybody to death. No wonder they became afraid of stocks.
Look please at the monthly flow of funds into Equity and Bond Mutual Funds in this chart. You can see the record high flows of money into equity funds in 1999 and 2000. Now look at the quantities of money that have flowed into bonds in the last two years. The current numbers dwarf whatever led to the bubble in 2000 by a long shot. Bond sales peaked in 2009 at $380 billion, almost 40% higher than the flow into equities a decade before. It’s not hard to spot a bubble when this kind of data is close at hand.
Data: Source NYT and Investment Company Institute
This chart shows that mutual fund sales of bond funds actually peaked almost a year ago, although sales do remain high. That isn’t what you would expect to see based on the never ending stream of talking heads on TV who say you must stay safe now and keep buying bonds. There is almost no time devoted on the daily shows as to why stocks might actually offer good value and be where you should be placing your money. Being a contrarian is how we make money for our clients at Gramercy Capital. Following the crowd is rarely the path to glory.
FEAR is now the main driver pushing folks into bonds. Nobody seems to care that you are being paid piddling amounts to lend your money to the U.S Treasury debt which has credit ratings that defy gravity. Our Government has never been so much in debt as it is now. Trillions are the new normal for Uncle Sam; not the billions we spent the 1990’s paying off so our children wouldn’t be saddled with a grim future. Instead of the greed of the Tech Bubble or the Housing Bubble we are looking into the future with such fear that we just want to get our money back.
Unsuspecting people seem not to grasp that bonds have now become the new bubble investment. Since 1992 when interest rates peaked, rates have spent 28 years declining to just about zero. When interest rates decline, the value of a bond investment rises, and conversely. If rates rise, your bonds decline in value. For 28 years, it was hard to lose money owning bonds. Even so people still preferred the better returns that stocks offered. That was true until Fear overtook Greed as the primary factor in the investment decision in the last two years.
Many astute bond observers expected higher rates as 2010 began. The U.S. Government has been selling unprecedented quantities of debt each and every week. At the same time, China and other international buyers of our debt have stepped away. It was logical to assume that our country would have had to pay higher rates to attract the needed capital. But instead, foolhardy Americans have rushed into the breach buying Treasuries left and right.
Most Americans agree that eventually, if our nation’s economy is ever again set right, interest rates must rise from near zero now. If our economy had shown itself to be healthier this year, that would have happened already. But the Federal Reserve Board keeps defining the economy as “fragile” and refusing to raise rates to upset the nascent feeble signs of improvement. So the question now is not IF rates will someday rise. It is only WHEN they will rise causing you to lose money as the value of your bonds declines. The longer the duration of your bonds, the more you need to worry.
The American Association of Individual Investors takes a weekly poll which has been published for more than 20 years. They track folks who are bullish on stocks and those who are bearish. These numbers, in both directions are driven by fear and by greed. A great example of both extremes occurred in 1987. In one particular week not long before the crash in 1987, 66% were stock bulls and only 6% were bearish. In October 1987, the bottom fell out of the market in a matter of just days. At that bottom in 1987 only 23% of investors were bullish on stocks, a higher number than the 20.7% at present. We’ve shown you above the euphoria of the tech bubble at the end of 1999. For eleven consecutive weeks from 11/24/99 to 2/3/00 the AAII numbers showed between 51 and 75% were bulls on stocks just as the market was peaking.
It’s not currently a popular point of view butGramercy Capital believes that buying bonds is afool’s errand right now, just as buying stocks was at the end of 1999. In AAII’s 8/26/10 report, 50% were bearish on stocks and only 21% were bullish. In reviewing the data, we found only three times, right at the bottom in 1990 (-67%), in October 2008 when Lehman collapsed (-61%), and in March 2009 just as the market began its vigorous upturn (-70%) that the bearish number exceed 60%. There are about 1200 entries in this series and less than 40 of them exceed 50%. Investors tend to be optimists. So numbers over 50% bears are not to be ignored and don’t happen very often.
That data goes right along with the following chart tracking analyst recommendations at brokerage firms. In recent years analysts have come to be the butt of major jokes on CNBC and Bloomberg. Ratings are cut after a major disappointment in company earnings, or just after its stock has collapsed. Hello! Analysts are more fearful now of issuing buy recommendations as a result in a less than robust market environment. Always with an eye to investment banking business for their firms, you will notice there are very few sell recommendations, even now in a punk economy. If there is one thing that I have learned for sure in my 45 years on Wall Street it is this: When the crowd agrees, it is always wrong. The only question for stocks now is timing.
The economy is punk. Unemployment is dismal. Foreclosures are rising. Government at all levels, national state and local is being forced to lay off people. That isn’t helping the unemployment numbers at all. People are saving and not shopping. They would rather have a buck in the bank than a new piece of clothing. Companies with good cash flow are hoarding their cash and not spending it or hiring more people. We are bereft of leadership in Washington. We have political gridlock and stonewalling. We don’t have an FDR to soothe the national psyche and enroll us in new ideas that might help our country going forward. Nobody is talking in a way to give us confidence and make us feel better.
All of this is known by everybody unless they are living in a cave or have been off fishing for the last year or more. What we don’t know is how soon things will get better. The stock market is as good a predictor of that as other leading indicators. Gloom about doom is as good a measure as any other.
We warn you not to be a lemming in the second definition above. When the bond bubble bursts, it will be just as ugly as the collapse in housing and the stock market proved to be. The only difference is that people will be more shocked that what they thought would be a safe place to put their money will hurt them again.
Instead, we believe your money should be in the unloved and undesired stock market. Remember that the number of bulls on 8/26 at 21% is quite similar to the 19% bullish reading at the bottom in March 2009.
Gramercy Capital believes that the best way to recover the money you have lost in recent years is to return your funds to the stock market. For sure, you will be hard pressed to restore your nest egg by owning bonds. For example, in May 2010 we bought DuPont for our clients at 36 after studying the company for a couple of years. The yield at that time was more than 4.5%, far more than the paltry yield on a Treasury bill or note. And, the stock is up 16% since then based on improved results across the board in its various businesses. It is the biggest gainer in the Dow this year. Hooray for knowing what you own and patient long term investing.
Joan E. Lappin CFA
Gramercy Capital Mgt. Corp.
Charts by Sherli Looi