What have we learned from the NASDAQ’s enormous drop, which has vaporized $4.8 trillion in paper wealth? Or the 44 percent drop of U.S. stocks as a whole, which Wilshire Associates says has cost $7.0 trillion? We should have learned not to believe in simplistic rules. But many of us haven’t. Rather, yesteryear’s bullish “verities”–you can’t go wrong owning stocks, you can retire early, good times can roll forever–have been replaced by equally fatuous bearish verities. To wit: you’ll always be safe owning bonds, you’ll never be able to retire, things will be awful forever.
The lesson we should have learned is that nothing lasts forever, and that joining the crowd is a good way to plunge off a cliff, like lemmings. If this sounds obvious to you, congratulations. But this point seems lost on a lot of people. Consider this. In the first quarter of 2000, which in hindsight was the worst time in memory to buy stocks and a great time to buy bonds, investors poured a record $105 billion into stock mutual funds and took a record $27 billion out of bond funds, according to Financial Research Corp. of Boston. Now, with stocks far less risky than three years ago (because on average they’ve fallen so much) and with bonds more risky (because they’ve risen so much), investors are pouring money into bonds and pulling out of stocks. It’s a bad-timing pattern you see over and over through market cycles. The moral: “What was hot yesterday won’t be hot tomorrow,” says David Haywood, a Financial Research senior consultant.
Three years ago people ranging from investment genius Warren Buffett to the Vanguard mutual-fund group to the occasional fuddy-duddy journalist were warning that stock prices were so high they had to fall. Who listened? Now Vanguard warns about the “irrational exuberance exhibited for bond funds by some investors,” and Bill Gross, the Buffett of bond-dom, warns that the “20-year bull market in bonds is likely now complete.” Despite these warnings, people are piling into bonds as a safe haven. Gross’s Pimco Total Return bond fund is now the nation’s biggest mutual fund. Enough said.
The end of a bull run in bonds doesn’t mean a slower bull. It means you can actually lose money. The problem is what bond mavens call “interest-rate risk.” Say you pay $1,000 for a shiny new 10-year U.S. Treasury bond that carries a 4 percent interest rate. You get $40 in interest a year. But say that the rate investors demand on such securities rises to 5 percent. This means that new bonds produce $50 in interest a year. Who’s gonna pay $1,000 to buy your $40 bond? No one who knows how to count. The only way for someone to earn 5 percent on your 4 percent bond is to pay you less than $1,000 for it–about $920. If you own the actual bond, you don’t have to recognize your loss by selling. Instead, you’ll lose by getting $10 a year less interest than with a 5 percent bond. But if you own shares in a bond fund, the loss in market value is inflicted on you because mutual funds value their assets daily. So if rates rise, your fund’s value falls.
Bond investors have done great lately because interest rates have fallen. This makes the price of bonds go up. It’s the opposite of the last example. But interest rates can’t fall much more. And they have plenty of room to rise, and almost certainly will. “You don’t want to see people stampede out of stocks into bonds,” Vanguard chairman Jack Brennan told me. “If we’ve learned anything the past few years, it’s that you should diversify your investments.”
I’m not telling you to buy stocks or to dump bonds. But sooner or later, stock prices will go up and bond prices will go down. If NASDAQ stays in business, we’ll be back above 5000 someday. Or some year. Meanwhile, I’ll hoist a glass every March 10 in memory of the bubble. Cheers.
