Two major warnings from history for investors in 2013

“2013 is the year that investors finally shake off their fear and dive back into the stock market.”

That’s something I’ve been hearing more and more often in recent weeks. There’s a ‘wall of money’ just waiting to pour out of bonds and flood into the stock market.

After all, why would anyone put more money into bonds? The returns are minuscule. Prices are so high and yields so low that even in the best-case scenarios, you’ll still barely make a bean. And with the worst of the crisis behind us, bonds now look very vulnerable to any rise in inflation.

So where else can people invest? It’s got to be good news for stocks.

At least, that’s what all the equity salespeople are saying. And their logic seems sound. There’s just one catch.

Bubbles don’t burst painlessly. And the bond bubble is highly unlikely to be any different…

1994 all over again?

2013 will be the year of what Bank of America Merrill Lynch analyst Michael Hartnett calls “the Great Rotation”.

Whatever you want to call it, it’s the point at which investors lose their terror of deflation, and instead start to fret about inflation. It’s the point at which they stop worrying about losing money, and start to worry about missing opportunities to make it.

And as far as the stock-market bulls are concerned, it’s great news. All the talk of the ‘death of equities’ has been greatly exaggerated. This is their comeback moment. This is when all that lovely money that has been locked up in the bond market comes flooding out and deluges the stock markets of the world, lifting all boats (not to mention fund managers’ pay packets).

It all sounds great. But as Hartnett points out: “the transition is very unlikely to be smooth.” He sees two big threats to “an orderly Great Rotation” – 1994 and 1987.

First, there’s the ‘bond shock’ scenario. In 1994, yields on 30-year US Treasuries (‘the long bond’) jumped by 2.4 percentage points in just nine months, as Ambrose Evans-Pritchard notes in The Telegraph. In case you’re wondering, that’s a big move.

Why did it happen? There’s a good archived article from Fortune magazine on the 1994 crash here. It all sounds rather familiar.

“In January 1994, the 34th month of economic expansion, bond yields were historically low and inflation seemed negligible: wages were going nowhere, and companies dared not raise prices.”

But there were some mild signs of inflationary pressures growing, with commodity prices rising. So the Federal Reserve started to very gently tighten monetary policy. At the time, Fed governor Alan Greenspan thought that if he was seen to be acting to fend off inflation quickly, it would bring down long-term bond yields.

So he raised interest rates from 3% to 3.25% in February. That’s a tiny move. But markets weren’t expecting it. Yields on 30-year Treasuries leaped higher as prices slid. And it got worse through the year.

There were plenty of reasons for the slide, but it boiled down to this: investors had been planning for a low interest-rate world. They’d bought up bonds all across the globe, ignoring signs of burgeoning recovery, or the threat of political risk in emerging markets. And of course, they’d used borrowed money to do it.

So even a hint of a change in the mood music caused a panic as bond investors rapidly re-evaluated their positions.

As Hartnett suggests, if we see a repeat of 1994 this year – perhaps the Fed eases up on quantitative easing – then the hardest-hit would be investors in high-yield bonds and emerging market debt.

Or worse still – 1987?

The other danger, says Hartnett, is that we see a repeat of the October 1987 stock-market crash. As well as rising bond yields, one of the many factors driving this crash was tension between the major economies over currency valuations. Again, this sounds worryingly familiar.

Hartnett sees a repeat of 1987 as “a low probability event”. However, at the same time, “many countries are trying to devalue their way to growth, risking a currency war… should gold start to respond favourably to this backdrop, we would certainly worry that a major risk correction is imminent.”

In short, whatever the equity sales people like to suggest, there’s unlikely to be a smooth sweep of all that lovely money directly from bond markets to stock markets. And the more bullish investors are (and they’re very bullish at the moment), the more likely we are to see a nasty correction happen in the process.

What should you do about it?

We’ve been saying for a while that bond markets look expensive. The main scenario in which government bonds would make you money from here is if there’s a major dose of deflation, and that now doesn’t look likely.

That makes them a very expensive form of deflation insurance. That’s why we’d have a minimal allocation to bonds in your portfolio just now.

Gold on the other hand is one of the best ways to insure against inflation. While gold is certainly not cheap today, given the reasonably high chance of inflation taking off in the future, it doesn’t look expensive either.

As for the rest of your portfolio, as we said last week, the key is to make sure you have a plan and stick to it. Hang on to cheap equities, maybe take profits on some of your more speculative positions, and keep some cash in reserve to take advantage of any crash opportunities that arise.

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  • Chester

    Much too early to write off deflation yet. We are still at the early stages of a significant correction in which the unexpected is likely to happen. Long term interest rates are on the rise, and the next leg down in equities and asset prices is likely to unfold very quickly. So both are likely to happen thanks to the huge distortions central bank manipulation has created

  • Lumino

    Re investment advice from the MoneyWeek experts… stopped clocks do tell the right time twice a day, it’s true, but you wouldn’t use them if you wanted to know the actual time, would you?

  • 4caster

    Not all bonds provide minuscule returns. Your colleague Bengt Saelensminde has recommended three with yields of around 8% in the last few months, although their yields have shaded somewhat as their prices have risen since their recommendation:
    Enterprise Inns 6.5% 2018 (secured against its properties):
    Co-operative Bank 5.5555% perpetual subordinated bond:
    Balfour Beatty 10.75% convertible preference share (OK, not strictly a bond).
    All are solid businesses which are unlikely to fail.
    Do you advise holders of these fixed interest securities to sell now and reinvest in equities that are at a 5-year high?

  • Roger

    Guys, the article calls you to sell government bonds, not corporate ones (that is a very complicated story), and preserve cash at the moment. When stocks slides (which will happen in the next few months), buy in, that is all what it says.

  • mikkip

    another shoddy article from moneyweek… FT mentions that bonds might be in for a downward correction and these muppets jump on the story and re-write it but in a dummed down way… great!

  • Reality Check

    Seem to be missing the point here about bonds. If the general public and the rest of the world stops buying them, then the BOE will just keep buying more themselves. As long as they have their own printing press they can keep the price suppressed for as long as they want.

  • Gold Bug

    “All the talk of the ‘death of equities’ has been greatly exaggerated. This is their comeback moment. This is when all that lovely money that has been locked up in the bond market comes flooding out and deluges the stock markets of the world”. Where have you been for the last four years John? The S&P has risen by over 120%. That hardly constitutes the ‘death of equities’.

  • Jonasdad

    It is misleading to use the term bonds when what you are talking about is Gilts. Returns on many corporate bonds are comfortably above inflation, and can be sheltered from tax very effectively. Whilst I accept that higher inflation will erode the return, I would rather place my trust in well managed companies than governments at the moment!

  • Pusser

    I think historical comparisons need to be flung out the window.

    We are in a new, electronic and instant fraud era designed by the well off for the well off but of course, the well off do not have to pay for it.

    If all the stuff flying around does not kick start a revolution, then nothing will.

    I find it hard to think of a company of repute that has no blemish, I find it hard to find a bank that has not stolen. I find it hard to find a political leader that has not lied or a war that has been honestly started with moral intentions. I am fed up to the teeth.

  • Ahmed (Helsinki-dishu, Finland)

    Put your money in gold and commodities, and your faith in beloved Allah. Avoid this predictable asset bubble from non stop money printing. The great crash from incredible greed is coming soon. May the prophet, peace be upon him, rescue us all.

  • Jack

    Deflation doesn’t look likely?

    Robert Prechter, who bases his analysis on waves of social mood would disagree.
    Harry Dent, who bases his analysis on demographics would also disagree.

    Both these gentlemen use parameters other than financial statistics to inform their analysis. Could it be that the financial statistics are misleading? It wouldn’t be the first time if they were (just go and ask Gordon Brown).

  • smlaing

    Sounds to me like the Commercial and Hedgies need a “great Rotation” in order to exit their positions in an orderly manner.

    It’s the same thing everytime………Commercials in first, hedgies in second, traders in third and good old mom & pop retail investors last……..”well someones got to take the losses!”