Saturday, March 20, 2010

The Illusion Of Safety

On the news you hear about how worried financial advisors are that the stock market has risen too far too fast.  They worry that the public has entered the market at the wrong time.

They are correct about half of that statement.  The American market has risen too soon too fast and has once again become overvalued based on historical P/E ratios.

The part they are incorrect on is that the public has entered the market. 

During 2009, bond mutual funds saw inflows of $440 billion.  Global Stock mutual funds saw inflows of only $45 billion.  American specific stock market funds saw inflows of only $800 million.  This trend has continued into 2010.

This important information can be looked at in multiple ways.

One way to view it is that because the public has yet to enter the stock market it could mean the stock market could head higher over the short term as investors try to catch the upward movement they have missed out on thus far.  I agree with that view, and think this cyclical bull market could head higher in the short term.  (However, remember that we are in a long term secular bear market for stocks and we have not come close to the ultimate lows in the market priced in gold)

Another way to look at this information is to say that the public has once again all headed in the wrong direction at the wrong time.

During 1999 the public poured into technology stocks just at they were set to explode.  In 2005 they poured into the safety of the housing market because home prices did not fall.  (At least not for the previous 70 years they didn't)  They did this just as the housing market was on the precipice of collapse.

Now they have all held hands and moved together into the bond markets.  They are buying up muncipal (state) debt, corporate debt, and federal government debt.

 Just as realtors told them they were making an excellent/safe investment back in 2005, financial advisors tell their clients today that bonds represent the ultimate form of safety. 

"Bonds don't go down like stocks.  They don't fall in price like real estate.  You are guaranteed your principle even though the return is small."

Ah, they can now take a deep breath and enjoy the feeling of safety.

What the financial advisors forgot to tell them is that you can lose money in bonds.  Not only can you lose some of your money, you can lose all your money.

Unlike real estate which will always have some value, bonds can go to zero.  How?  The entity you loaned money to cannot or does not want to pay you back.  That is all a bond is; lending money for a rate of interest.

We have been in a bull market for bonds since 1981.  That is 29 years running.  That is longer than most financial advisors have been in the business.  Not only are we entering a bear market for bonds, I believe it is the last great bubble to burst.  Proceed with caution, extreme caution.

An obvious question is, how has the stock market risen if the public has not entered the market.  The answer is through the commercials moving the market higher.  This entire rally has been driven with very low volume.  That means that the high frequency traders such as Goldman Sachs have the ability to move the market with ease.

Unless the public decides to enter, the market will go up as long as the commercials want it to.  When they don't, look out below.  The next thirty days will be extremely important as the Federal Reserve begins its "exit" strategy out of the markets.  Their lack of impact could be the catalyst for the next major move in many asset classes.

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