The opening weeks of 2013 have seen the investing public, in the US and in most other countries, pouring money into equity investments. The clearest evidence of this was the data showing that the scale of purchases of mutual funds and ETFs specializing in equity markets during January was the largest ever — and the trend continued in the first few days of February. This is a major change from the dominant theme in the financial markets in recent years, which has been the relentless surge of money into the bond market, whilst the general public has been withdrawing money from equities.
While these facts are clear, their implications have – as usual – been a matter of fierce debate. On the one hand, the ‘bulls’ have viewed this development as the belated realization by the investing public that there is a bull market underway in equities, and that the arrival of the individual investor in this market will ‘give it legs’ – i.e. enable it to continue higher and for longer. The ‘bears’ see the belated arrival of the retail market as the death-knell of the market’s ongoing rally, since the general public can be relied upon to display the worst possible timing – buying shares when they are already high and selling them at the depths of the slump.
But what almost everyone is agreed upon is that the bond market is dangerous. This is a remarkable state of affairs by any standards. In theory, bonds are safer than shares, because they have elements of certainty that shares lack. A bond carries a coupon that says how much interest the bondholder will receive. More critically, a bond has a redemption date, at which point the bondholder will receive the principal amount of the loan, in addition to the regular interest payment. Shares, in contrast, may have a dividend paid on them, but there is no absolute commitment to the size or regularity of the dividend payment – it could increase, decrease or disappear altogether, depending on what the board of directors decides. What is certain is that the capital paid into the company by the initial purchasers of its shares will never be repaid.
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It is thus a thought-provoking reflection of the extraordinary situation pertaining in the markets that bonds are considered, especially by experts but even by laymen, to be more dangerous investments today than are shares. The shallow element in the thinking behind this view is that short-term interest rates are at zero and therefore have nowhere to go but up. Since bond prices move inversely to bond yields (interest rates) it follows that all the risk in bonds is to the downside – interest rates cannot fall further, so bond prices cannot rise, but interest rates can and one day will rise, so bond prices must eventually fall. Shares prices have no such dependence on interest rates, therefore they are not similarly marked for decline.
This is a simplistic view, because the standard formula for valuing shares relates their price to the value of the expected income stream that they will generate – and this future income stream can only be calculated by discounting the future income at the current ‘risk-free’ rate of interest, defined as that available on government bonds. Thus share value is implicitly linked to interest rates. Indeed, using this formula or anything similar to it leads to the conclusion that if bonds fall because of rising interest rates, then share prices will too, albeit not necessarily at the same tie and certainly not to the same extent – unless the profits of the underlying companies rise by enough to offset the negative impact of rising interest rates. This is possible, but far from certain, let alone inevitable.
Nevertheless, as a recent trip to the US made abundantly clear, ‘everyone’ now believes that bonds are dangerous because they are “so high” – i.e. interest rates are so low and “must rise at some point”. Indeed, because the coming fall in bonds is seeen as ‘inevitable’, it has become commonplace to describe the bonds market as ‘a bubble’, because anything considered overvalued and hence destined to decline in price is nowadays labeled a bubble.
Whether this thinking lies behind the move into shares is unclear, because there has been no parallel massive move out of bonds. All that has happened is that the flow INTO bonds has significantly slowed – but that may still hide a move out of bonds by the general public, because the Federal Reserve is pumping no less than $85 billion into the American bond market every month via purchases of government and agency debt.
The Japanese government has now adopted an even more aggressive policy of reflation and, as discussed here a few weeks ago, is seeking to create inflation and force the Japanese economy out of its deflationary spiral. Yet so far, at least, this new policy has not had a noticeable impact on the Japanese bond market – although it has had a massive impact on the currency (a devaluation in excess of 20%) and on the share market (a rise of similar magnitude). This stands in sharp contrast to the US, where long-term bond yields have been trending higher for many months, despite the Fed’s announced intention of holding short-term rates at zero through 2015 and pushing longer-term rates lower. If there is a bubble in any bond market, it is in Japan, yet it is the American market that is showing stress – so far. Stay tuned, because the bond market is the critical arena.