Swimming Against the Stream

Bond funds are all the rage these days. While stock funds keep losing assets as investors yank their money out, bond funds are gathering billions. Since March of 2011 investors have pulled $163 billion out of stock mutual funds. On the other hand, they have showered $205 billion on bond funds. (Numbers are from the Investment Company Institute, see here).

Ordinarily, the mere fact that money leaves stocks is enough to suppress returns because selling leads to lower prices. But in these last several months, that connection has broken. Despite the heavy outflows, stocks have been producing outsized returns. Over the last six months, the S&P 500 is up well over 20% – a huge rally in a short time. Meanwhile, bonds have started to falter. The Barclays Gov’t/Credit bond index is up only 1.1% over the same time frame.

It’s been no secret that investors have less appetite for risk than they did pre-2008. The market crash brought to you courtesy of Lehman Brothers and the housing mess, the wild swings fed by the bumbling Euro Pols, and the decline in interest rates set off a scramble for safety and income starting in late 2008. But enough is enough. Bonds have outperformed stocks for a solid decade, and that’s not reasonable. The higher risk asset must eventually return more than the low risk asset.

We think that the longer investors shun stocks, the more likely it is that the rally will continue, and to a surprising extent. On the flip side, we’d be very wary of making large new commitments to bonds – government bonds in particular. There is no doubt that the government bond market remains substantially manipulated by the Fed, and the very thing that’s going to make the Fed back off – an improving economy – is the thing that will hurt bond prices even more.