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Stocks, Bonds, or Short? – The Million Dollar Question

August 14, 2013

In the 1990s, tech stocks were the place to be. After the dot-com bust, those who placed their money in bonds or shorted stocks did very well until October 2002. The winning asset class between late 2002 and October 2007 was stocks. History tells us picking the right asset class buckets is extremely important in the quest for satisfying investment returns.

Limited Capital To Allocate To Buckets

With central banks around the globe skewing the prices of stocks and bonds via artificially low interest rates, it is harder than ever to make allocation decisions.

Investors are reluctant to hold bonds with interest rates near all-time lows. Trepidation is justified on the equity side as well with the Fed hinting strongly at cutting back on “easy money” policies that have supported risk taking. In recent weeks, stocks have treaded water, but bond buyers have helped stabilize interest rates. From the Wall Street Journal:

Investors’ return to bonds shows they have begun to buy into the Fed’s statements that the financial health of the U.S. is improving, and into its assurances it would pull back only if the economy showed it could withstand less help. As the summer wore on, employment growth was moderate and inflation remained low, which helped ease concerns that the central bank may act quickly. Fed officials also said the central bank has no plans to raise benchmark interest rates before next year. “As people settled down and thought about it a little bit, the catalyst for the end of quantitative easing is going to be an improving economy,” said Joe Mayo, managing director and head of credit research at Conning & Co., which manages $82 billion in assets largely for insurance companies. “An improving economy is positive for risk assets.”

Taking It Day By Day

With GDP figures in the U.S. remaining tepid and the eurozone still hovering near the zero-growth line, investors are having a hard time buying into the improving economy scenario. If we add the possibility of Fed tapering into the investment equation, the waters get even more cloudy. A recent debate on Twitter about the Fed’s possible tapering schedule highlighted an important tenet of successful investing, especially during periods of uncertainty.

Paying Attention Works

Before you dismiss the value of letting the markets guide us day-by-day, we noted in the opening paragraph:

After the dot-com bust, those who placed their money in bonds or shorted stocks did very well until October 2002.

With the benefit of hindsight, the statement above seems obvious to anyone who lived through the 2000-2002 bear market in stocks. Was there a logical way to sidestep the painful losses experienced by stockholders? Yes - by simply paying attention to what was happening, rather than focusing on what might happen next, the charts below clearly identified a shift from “risk-on” to “risk-off” that occurred as the dot-com bubble was being deflated. In the second half of 2000, with the S&P 500 ETF (SPY) trading near $112, a clear and observable shift favoring bonds over stocks had taken place. After the charts said “bonds are a better place to be than stocks”, SPY dropped an additional 44% before hitting bottom at $63.14 in October 2002. Section A in the image below shows the performance of the Vanguard Total Bond Market mutual fund (VBMFX) relative the S&P 500. Section B is SPY in isolation. Section C is bonds in isolation.

What Are The Markets Telling Us Now?

As we noted August 11, bullish momentum has slowed noticeably in recent weeks, which tells us to keep an open mind about further weakness in stocks. However, slowing bullish momentum alone is not a reason to run for the stock market exits. We need to see observable evidence of a change in risk tolerance. The chart below shows the weekly trends continue to clearly favor stocks over bonds (AGG).

If you are still skeptical of the value of paying attention day-by-day, notice how the chart below of longs (SPY) vs. shorts (SH) helped identify the fall 2012 peak, November 2012 low, and recent May 2013 pullback. As of August 13, investors continue to favor being long over “going short”.

Tapering To Be Pushed Out?

Our market model has a risk-on vs. risk-off component, which includes analysis of the charts presented in this article. The model also digs deeper comparing over 130 ETFs head-to-head in search of the investment buckets that are in greatest demand. The model’s current read on the big picture continues to have a reflationary look to it; meaning QE-friendly emerging markets (EEM), silver (SLV), and materials (XLB) have attracted interest from buyers. Said another way, recent ETF leadership seems to point to ongoing assistance from the Fed, rather than significant tapering in the months ahead. Wednesday’s news on the inflation front gives the Fed a little more wiggle room to remain highly accommodative. From Reuters:

U.S. producer prices were flat in July and pointed to very little inflationary pressure in the economy, which could add to worries at the U.S. Federal Reserve that inflation is running too low.

Investment Implications

Why do the charts above add value? The help us monitor the demand of risk-on assets relative to risk-off assets. Supply and demand determine the value of the assets in our investment portfolios. As long as the demand for stocks is greater than the demand for bonds, we will continue to hold broad stock market positions (SPY). In a similar vein, as long as the demand for long positions is greater than the demand for short positions, we will continue to hold our ground in leading sectors, such as technology (QQQ), small caps (IWM), clean energy (PBW), and financials (XLF). Taking it day-by-day speaks to flexibility. We will leave our holdings alone until the market tells us to do otherwise.

The melting point of gold is 1337.33 K (1064.18 °C, 1947.52 °F).
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