Below is a commentary I published on March 8th. Like Warren Buffet, I was especially worried about the bond market. During the months before I posted the article, huge inflows into fixed income funds took place. Suddenly investors began selling bond funds to buy stocks.

As I anticipated, bond prices have since declined – many retail investors still don’t realize that a bond fund has altogether different dynamics than holding actual bonds. When the fund sells bonds (or derivatives replicating the bonds) or the investor redeems then capital losses are crystallized. You will note that I suggested at the time that cash (or equivalents) might be wiser than switching directly into equities.

Why?
I did predict that aggressive fund flows (everyone seemed to be chasing equities) would lift stocks about another 10% (it turned out to be 9.75%) before a serious correction would undermine the bull market. Nonetheless I’ve learned that investors getting sucked into a buying frenzy usually risk buying right up to and at the peak; and then getting whipsawed. Having cash available to put to work during a correction is never such a bad thing.

The following was published March 8th,2013

Selling bonds to buy stocks? Try door #3 instead!

I have been warning about bonds now for over 6 months. Finally the press is catching on, ensuring that a normal development over the course of a business cycle (whether ignited by natural forces or government intervention) – rising interest rates – might cause investors to panic. Even Warren Buffet has delicately sent up a warning flare in his TV interviews suggesting the worst investment at present is a long term government bond.

And there’s this too:

Over at UBS, a plan is being discussed to reclassify bond investors as “aggressive” investors…UBS is planning a mass mailing to many of its brokerage clients alerting them that they have been reclassified as “aggressive” investors following a recent change in its market outlook that some people inside the firm say reflects growing bearishness in the bond market, particularly over the long term, the FOXBusiness Network has learned… (thank-you for this quote Stephen Bishop of Nova Scotia).

This is scary, but makes sense. If interest rates rise, taking down the valuation of bonds on the balance sheets and assets under management rapidly, then banks and insurance companies (loaded up on bonds during and post-financial crisis) will be hit with more financial woes. They all scrambled back then to reduce risk, but are discovering belatedly that at the drop of a hat they added more risk than they bargained for. What’s the best way to get clients to trim their bonds and bond funds? Have compliance make the security unsuitable.

I’ve been warning about this since last summer….the question is not ‘whether rates will rise’ because in reality the trend (see chart for US Treasuries) has been slowly but unequivocally UP for awhile, especially at the long end of the yield curve.

What happens when everyone wants out all at once? Watch the below video.

What we risk is turning what was a bond bubble into another stock bubble. As I suggested in my previous commentary the stock market has to go higher as money flows (funds from gold exchange-traded fund or ETF redemptions, proceeds from bond sales) gotta go somewhere, and they’ve been moving into the stock market with gusto for many months now. My target was another +10% for the S&P 500 to get to fair value, but markets have a tendency to overshoot (hence to term ‘bubble’) don’t they?

There’s no shame in beating the others – like George in the video – out the door (selling bonds) but it may be wise at this stage to hold onto cash rather than dive into the stock market full tilt. Look for an opportunity to buy back some bonds at higher yields during the summer and top up stocks when the next correction comes.