Coronavirus Teaches Us to Use Bonds the Right Way

Coronavirus

Back on January 24, the stock market began to buckle under the force of the coronavirus, we told you it was time for gold, but bonds have been picking up as well.

Investors tend to hold a lot of bonds, presumably for a rainy day, although given that the sun shines most of the time, they don’t understand how bad this is for them or the fact that we should even be timing these things.

When we take a big step back and compare the longer-term results of bonds versus stocks, stocks simply clobber them. During bull markets with stocks, they also provide more steady returns than bonds do, as bonds can be all over the place during these times, as we see when we look at a 10-year chart of the iShares 20+ Treasury ETF.

This chart would be an eye-opener for a lot of people who don’t really understand how bonds move. We have only seen one significant move down with stocks over this time, but there has been a total of 4 major moves with bonds, with some of them even worse than the tumble we took in the stock market in late 2018.

Stocks go up mostly, but bonds mostly bounce up and down like a yo-yo, and during stock bear markets, there’s more volatility to the downside with bonds than with stocks.

It’s the way bonds pale on the return side that stands out the most though. Over the last 5 years, this bond fund wasn’t up at all until the last couple of weeks, and all you’d have to show for all these years is the little 5% rally since. The Nasdaq, on the other hand, has doubled in value in the last 5 years.

It makes no sense to have all your money in bonds, half your money in bonds, or even a small portion in bonds during a bull market with stocks. The majority of investors do hold a good amount of bonds in their portfolio, but this is due to their having no idea of what they are doing, because if they did, they would never choose this approach.

Bonds can be a valuable tool in your investment toolkit when it actually does make sense to hold them, and in fact, when this happens, we want to be going all in with them. For instance, the coronavirus threat that we are under, not the virus itself but the way that the Chinese economy is being restricted, is an example of one of these times.

We invest for one reason, to make a profit. To do that, we need to have our money in the right places at the right times. Having it in stocks when they are running up is simply the best place to have it during these times. We can have a reasonable expectation of bull markets continuing, but no one ever knows for certain what the future might be, and we do need to be adequately prepared for whatever may come our way.

Why would anyone put 40%, 50%, or more of their money in bonds in both the best and worst times? If stocks are running better, wouldn’t it be more sensible to have our money in stocks? If bonds take over and outperform stocks for a time, which happens once in a while but not very often, wouldn’t it make sense to have our money in bonds, or something else like gold, when those assets are making us money instead of seeing ourselves lose?

Lose is a relative term, and while we generally only spot losses when we actually lose money, comparative losses count for just as much. Those completely invested in bonds over the last 5 years have lost 100% of the value of their investments, where if they had $100,000, they still have this amount but have walked away from another $100,000 over this time. If you went half and half, which is much more typical, you’ve lost $50,000. 40% in bonds adds up to a $40,000 loss.

$100,000 is not a lot of money to retire on and is way short of what people need, and the majority of people end up harming themselves in retirement because they left so much money on the table. Even this extra $40,000 would go a long way down the road when you need it, but people just carry on like always because this requires some thought to figure out, and neither they nor the people advising them have dared to question any of this.

Anytime you see people acting this irrationally, there’s a story behind it, and in this case, it is people chaining themselves to their investments and refusing to unlock their chains when they need to or even when it would be incredibly stupid not to is their undoing.

Choosing Between Stocks and Bonds Is Simpler Than People Think

They think that deciding when to run is too complicated, but deciding between stocks and bonds is actually a very simple practice once you realize what we’re even trying to do here, or at least should be trying to do, which is choosing what is working over what is not.

Understanding this would also help people choose stocks much better, and this isn’t complicated either, you hold the good ones and toss the bad ones. If a stock doing well, you don’t worry about it being good now as long as it remains good, and when the time comes where our money would be doing more for us elsewhere, that’s the time we need to be moving it.

The same applies to assets. If bonds are outperforming other securities, your money is in bonds, all of your money. When stocks take over again, you get back in stocks. This is similar to how a record company runs their businesses, making records with popular artists or at least ones with enough potential, and those who are no longer popular don’t get re-signed and end up at casinos and county fairs.

This is how we do business in general, and is how the companies that we buy stock in do it, because otherwise you just won’t be able to compete. We’re running a business with our investing but very few indeed treat it that way, instead being happy enough to remain under the spell of broken reasoning that persists like a bad disease that grips the world.

This is a lot like confronting addiction, where the first step is to admit you have a problem, and until then, the problem remains unopposed. Those who do get this, few of which are individual investors, are all over transition periods and this is the sole reason why you see stock prices go down and bond prices go up during times of market fear.

We are in the grips of one of these scenarios now, and the Chinese coronavirus won’t make any dent in the number of people who die each year from infectious diseases, where a mere thousand or two isn’t enough to move the needle noticeably. Millions of people die every year from infectious diseases, so something that perhaps kills a thousand and comes around every decade or two just isn’t meaningful.

However, the response to this panic is another story. The SARS epidemic cost the economy plenty enough, but this response is more aggressive and damaging in itself, and especially so given how much the Chinese economy has grown in the last 17 years. This is a much bigger deal than the trade war ever was, so if the trade war bothered the stock market, this will all the more in time, when both the body count and GDP losses are finally tallied.

Seeing major Chinese cities locked down, at the time that they first did this, is a major red flag to the economist, because this degree of interference with the free market in itself will be painful. This took a little time to sink in, but the market finally started to react to this, once the incubation period passed, and we really saw some symptoms of this bug surface last Friday when stocks got simply hammered.

With a lot of news stories, you just price in the damage and move on, and the price that is set tends to be too high and this can provide some good trading opportunities to play the rebound. With the coronavirus, we do not even have a good idea about how bad this will be, and the 1% shaving off Chinese GDP that is being thrown around now seems on the low side if anything.

This situation could take months to fully play out, with the Chinese economy getting sicker and sicker by the day all the while. This lockdown truly was a call to arms for investors, a time that at the very least does not look promising to be in stocks.

Should we decide to put our financial face masks on, this does not mean just cutting down a little on our exposure to the financial virus, as to do this sensibly, we need to emulate the Chinese and quarantine ourselves from stocks. Gold remains a good choice, but bonds are where most of the money goes in a panic and the money is really flowing now.

Bonds Look Much Better Than Stocks Do Now

As badly as the Nasdaq shames bond returns overall, it is down 3% since January 23, when the mass quarantine started, while our bond fund is up 3%. No one with the slightest idea of how stocks and bonds work should be surprised by this. This is just how these things work during a crisis and this one does qualify as that.

In comparison, gold has gained 1.5% over this time, half as much as bonds have, but gaining a percentage and a half is sure better than losing 3%. Bonds are in territory where it takes a lot more than normal to push them higher, where gold has no such natural limits, but this is about being in something while the sun shines and if it goes behind the clouds with bonds, that means it’s time to leave them as well.

We could see a time where all three are performing badly, but there’s always cash, which always does well and is the only save haven for all weather. When investors become afraid though, you can count on one or both of these other assets to get some extra love if they are trending up already.

Bonds do well in a crisis with few exceptions, with one of them being the financial crisis of 2008. People actually worried about the Treasury defaulting back then, a time which should have put the price of treasuries up a lot, not just because we’d expect people to bid them up but because bonds love it when inflation goes down. The only explanation for bonds going down instead is default risk, and although that wasn’t even possible, fear is more than enough and the more you fear, the less you think.

The market may not be on the right side of the truth, but if we are on the wrong side of the market, thinking that we were right does not help us one bit. Whatever the reaction that we think may be to something, it’s a guess at best and we need to pay attention to the actual facts as they play out, and listen to them carefully as they speak.

2008 was a rather unique threat though, although the point of bringing this up is to explain that this is not a stocks or bonds thing, as neither may be suitable in certain situations. The very idea that we should be using suitability to determine which investments are suitable for us is a concept that few investors understand, to their detriment. Investing doesn’t require a lot of thinking, but you do need to do a little, and the great majority insist on none.

We will no doubt see some rallies along the way, but it’s hard to imagine anyone not being concerned about this. The risk with getting out is that you would have ended up making more money by staying in stocks, and even if this were a positive number, the value of the protection that this provides is worth quite a bit.

However, stocks outperforming bonds while the coronavirus still grips China is not likely at all. Not likely at all is beyond the threshold we need to decide, and this one is very unlikely indeed. We get the value of the hedge plus the performance differential, which is already at 6% and may easily end up quite a bit higher before this show ends.

As stocks continue to move lower, every additional percentage down makes the boat rock more, throwing more and more people overboard. We will price all this damage in and then some at some point, but we’re not even sure how bad it will be at this point, and all indications are that this could go on for quite a while.

Bonds and gold are both serving as a nice lifeboat right now, and if you like either, you have a good reason now to jump on one of these rafts. Going half and half with them isn’t a bad idea either, and when both are outperforming stocks like they are now, a little diversity doesn’t hurt.

This has all caused the quibbling that people do about what percentage of people’s portfolio should be in stocks increase, and some are suggesting we go lower and more into bonds than ever. That’s an important first step in actually figuring out what the right thing to do is, actually taking action based upon need.

All that’s left to figure out is why we would prefer any percentage of our assets to be left for the dogs when they come around, and then try to see through all the rationalizations that come to mind. This likely won’t be that big of a hit, but wanting to expose any of our wealth to situations with a negative expectation for a time just does not make sense.

Figuring this out is not a matter of having a huge research department, using esoteric technical tools, or relying on crystal balls. You have an issue. The issue puts your stocks at real risk. You take action. When the problem ends and when stocks pick up again, you will know it.

The market could open up on Monday and totally ignore all this, as well as other things that are bothering them such Bernie Sanders moving up the polls, and we could just bust through previous highs and just keep going. We need to go with what scenario is more likely, which this definitely is not, and understand that as long as we’re on the right side of probability, particular outcomes do not matter and we should never second-guess ourselves this way.

The response to this virus has provided us with as reliable of an indicator of a storm ahead as there is, where we’re often left to guess a lot more like in the final quarter of 2018. The coronavirus is almost like money in the bank, and those who bet on this have gains instead of losses to show for it. It’s better to make money than to lose it, and anyone would agree that this is their goal, they just need to get a whole lot better in putting their plan into action.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

Contact John: [email protected]

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