Investors Allegedly Fleeing to “Safer Assets” Now

Investors

Treasuries are rallying a bit after we got to see what the GDP losses were last quarter in black and white. The idea that this represents investors fleeing to safer assets is amusing.

Yesterday’s article contrasted the fear that people feel about the stock market versus the actual fear that may be going on in it, and particularly how they fear future outcomes and will act just like the threat is actually present, conjuring up the worst and then running from it.

Make no mistake, our economy is in turmoil right now, and normally when economies are in turmoil, the stock market is as well. We can look back at how stocks have done during recessions in the past, but just because stocks may have joined the mourning each and every time this has happened so far, we cannot act with confidence on this data alone, because results may differ.

The only way that we can tell if a given instance differs from the norm is to observe it manifest, a we can use the past to guide us in the present but are not entitled to replace the present with it. If it is sunny for 30 days in a row, we cannot just leave our umbrella behind without checking out the present weather because today may be different.

We hopefully are coming to realize that we have the power to simply look away from a lot of fundamental negativity, from the economy itself even, and just continue to bid up certain stocks or even the market as a whole if we wish. The only reason why we have not done this very much before is that we did not choose this path, but we could, and right now, we are.

It is not so difficult to figure out what to do in order to succeed as investors, as we just need to watch how the money is flowing and how this is affecting performance in a positive or negative way and pursue the positive and avoid the negative. If we are bidding something up, we should want to be in on these things, and when something is in decline, we should not wish to share in the pain.

Investing is a game of probabilities, and while no one can be right all the time, we at least need to try our best to be more right as well as trying our best to avoid being wrong. When the final score is tallied, our success will be measured by how well we manage this seeking success and avoiding failure.

As long as assets move, there will always be a right and wrong side in terms of probability, where we seek to be on the long side during advances and be on the right side during declines as well, the side that sees our assets increase rather than decrease in value during these times.

When we get this wrong, when we either choose the wrong side or to be in the wrong investments at the wrong time, reflecting back upon this should provide us an opportunity to improve our understanding, and this is the process that traders use to eventually become good traders.

Few investors do this though, even iconic ones, not realizing that achieving true success in speculating on securities always needs to start by asking the right questions, how we could have done better, rather than being content to never ask these questions and become doomed to make the same mistakes over and over again.

Even in the midst of this pandemic and the economic turmoil that trying to beat it back has resulted in, the sun can shine on stocks, particularly certain stocks that are not prone to this sort of damage and even may prosper even more under these conditions.

While people have succeeded to some degree by just looking to own representative baskets of the stock market such as the S&P 500, this has never been that good of an approach, as those who have been bold enough to use differentiation to choose which ones to put their money in have always had a big advantage.

This differentiation has become even more important now as the market itself has chosen to reward the haves and punish the have-nots on a bigger scale than we have ever seen before, where the disparate nature of the COVID era has pushed investors into recognizing more that some stocks are just better than others.

This has always been the case, but it is true even more so today, and the gap widening from this is serving to educate investors more, where we are following the money more than we ever have before.

We make this game a lot harder than it is, and if this challenge were presented to people in the format of an online game, disguising its nature to ensure that the biases people hold about investing are left out, a person of only average intelligence could ace this, easily pointing themselves towards things that do well and being steered away from the poorly performing stuff.

They don’t do that well at the real game though, the one played online at their brokers’ sites, because along with the ability to play the game, they are well indoctrinated to use various strategies that yield much poorer results than they got playing the non-monetary version of this, where we just use our intellect to detect the most basic of patterns and trade on that instead of in accordance with the prevailing creed.

We must delve into the differences in performance that we see between these two activities, and it turns out that we do not fear the outcomes of the play game, but we are very much afraid when we play the real game. When we go deeper and examine this fear, we see that it is actually a fear of success, where we are now afraid to go with the good choices that we made in the play game and somehow are less afraid of the bad choices.

Needless to say, this will result in quite a disparity of results. The better a choice is, the more it scares us, although we are not afraid at all to pick the wrong things and even stick with them as their wrongness continues to unfurl.

They see an index like the S&P 500, and go with that because picking a better performing index has them more afraid. They are even more scared of picking the good stocks from this index and avoiding the bad ones, because the better something does, the scarier it is.

They are even too scared to just go with this index, and feel more comfortable watering down their returns even more, with things like bonds. Their gods have commanded them to hold 40-50% of their assets in bonds, as putting all your money in even a mediocre performing index performs too well for their tastes, which they feel the intense need to obey and reduce their returns significantly more.

While this is not by way of an overt conspiracy, as the conspirators themselves are lost within this madness as well, there are some good macro reasons to have this in place, starting with the need to maintain liquidity for all of the stocks that underperform, or for bonds in general.

The more interest you can generate for a stock when you issue stock, and the more interest you can drum up for any sort of debt instrument like treasuries, corporate bonds, municipal bonds, or what have you, the more money you can generate from issuing these things. On a macro level, if everyone did the sensible thing and pursued a course toward investment success, the landscape would look very different and governments and companies would struggle a lot more than they do in raising money.

The Markets Run the Show and We Need to Pay Attention

Imagine if everyone just decided to sell everything and buy only Amazon stock. Amazon’s market cap would explode by 100 times and everyone would be seeing obscene returns, returns that would also continue to grow from all the new money put into this, but everything else would be flattened.

This is not just a hypothetical scenario as we could do such a thing if we wanted to, and Amazon could just keep issuing more and more stock to satisfy this voracious appetite for it, and the price would explode and just keep on rising as the money keeps flowing into it on a net basis.

Don’t count on that ever happening or anything close though, but this would actually represent the optimal macro solution for return at least, in spite of the devasting consequences that it would represent to the economy. With people just going all in with Amazon, nothing else will matter though, as this determines its path deliberately and without any other inputs.

As individual investors though, it is not even our place to worry about these things, but we can rest assured that we can act in accordance with seeking the optimal without ever having to worry about so many people joining us that this will cause turmoil in the markets as a whole. Our general ignorance will serve to protect us from this, and will continue to, as even contemplating such a thing is well beyond people’s imaginations.

We won’t ever get close to this, but we will get closer. We are seeing ourselves move toward such a transition more and more though, the transition from allowing our fear and misunderstanding of investing to guide us so much to at least seeing more of us loosen our bonds somewhat, where the bankrupt idea of severely limiting our results in the name of diversity is at least fading a little more now.

While we remain for the most part afraid of success with stocks, fear plays an even bigger role with our bond investments. Bonds are not the little brother of stocks, as stocks are actually the little guy in comparison, as the bond market is about twice as big as the stock market. As we speak of the role of fear in investing, as we are doing in this two-part series on it, we would be negligent if we didn’t speak of how fear controls bond investing as well.

This issue comes up every time we discuss bonds, and it’s not that we have any bias against them, and investing bias in itself is the disease we’re looking to address with these discussions in fact. It is not unreasonable to expect investments to stand on their own merits, rather than our imparting some pretty extreme bias into the calculation, where bias here means deciding on something else other than the facts.

While living in a cardboard box is not a prospect that people should find appealing, climbing into one when the rain falls too hard can serve to shield us from this, while the rain is still falling. When it stops, it no longer makes sense to be in it and we are now free to pursue the much greener pastures that are out there. The box can sometimes be the best choice, but only when it actually is.

If you ask the average investor why he or she hangs out so much in this cardboard box we call bonds, and if they are being honest, they will tell you that they are too afraid of greener pastures. The greener the pasture, the more afraid they are of it. Somehow, they are not afraid of the box, where they can hide from reality and not have to worry about imagined muggers robbing them, even though they have to pass a bunch of warning signs and stubbornly proceed in spite of the clear warnings before we allow ourselves to be rolled.

We spoke of distinguishing between our own fears and whatever fear that markets may have, whether it is with a particular stock or the market itself, and the importance of letting the fear that matters, the market fear that actually impacts these stocks in a material way, guide our actions instead of choosing a contrary path that ends up pushing us away from the good toward the bad.

Anytime we hold bonds when the sun is shining on stocks, this response is purely out of these misplaced fears, because if the stock market is not afraid, we certainly should not be either. Holding bonds at all is a complete testament to the impact of this irrationality, so we don’t want to stop this discussion at stocks.

We don’t understand stocks very well, but we misunderstand bonds considerably more, even though not understanding stocks is the lack that creates the need to even think about bonds. If we are looking to grow our money, it doesn’t make any sense to choose something that does so poorly in comparison overall, but it’s not performance that drives this mistake, it is fear, pure and simple.

If we are afraid of performance and avoid it, something performing more poorly may please our psyche, but it’s our accounts that we need to be thinking of here. There are even a lot of investors who are so afraid that they will go all in with these terribly performing assets, even though doing so may guarantee that they end up living like paupers.

The investing analogy in the Bible where money is given to both a fearless and fearful investor, with the fearless one investing it wisely and growing his money, and the fearful one even losing what he had, is very apt and worth mentioning again. Being a parable that applies to life in general, this captures the destructive element of fear in more than just investing, but it certainly applies to it.

We want to be more like the good guy in this scenario, and certainly do not want to be the fool who lost everything from being too afraid to succeed. We never want to be that person in investing or in life, but we will never get there unless we can finally cast off the fear that this parable is warning us of.

Reason Rather Than Fear Needs to Prevail

We always need to examine whatever strategies we use by way of their actual merit, and cannot just accept one without even thinking about it, as wildly popular as that may be. If we’re willing to accept lower returns on our investments, and no one would ever question that bonds do this overall, we need to understand why we should ever want to, and whether this is the best approach to deal with whatever issue that we’re so afraid of.

Whether we realize or admit it, there is only one possible good reason to be in one asset over another, to advantage ourselves of the times where the secondary asset will outperform the other. This always is about performance, otherwise the choice would be completely stupid as this excludes the possibility of any advantage.

There are times when bonds outperform stocks, and these times show themselves particularly well, like when stocks started to sell off last February at a time when bonds were doing quite well. The rest of the time, the overwhelming majority of the time in fact, stocks outperform notably, and it shouldn’t be so difficult to realize that these are completely different situations and must be treated differently if we wish to be even sensible.

Ironically, even if our mantra is to refuse to ever act even in times where it is to our extreme and obvious advantage to do so, we aren’t entitled to just assume that we need to give up a big chunk of our money to compensate for this lack, and this along with everything else needs to at least be examined.

The path to progress always requires that we examine alternative courses of actions before we choose, like we would do when we look at how putting all of our money in stocks and chaining ourselves to them without exception does versus only chaining one arm to stocks and the other one to bonds that massively prevails among individual investors.

If we dare do such a thing, our mouths will hang open wide as we see what the price of this dual chaining has cost us. If we approach this with a calm and calculating mind, the amount of calculating it takes to know that a much bigger number is better and the calmness to act upon this information, this alone will wake us up to the fact that asset diversity should be based upon need and not some mindless sowing the wind and reaping the whirlwind that the Bible also warns us about.

Investors love to interpret things way too narrowly and they certainly do so with the concept of portfolio risk. Risk and return function together, and this should be very obvious, but what we do instead is to try to isolate risk and ignore the effect of returns on it and this paints some very distorted and harmful pictures.

We then look at things like the 35% drawdown we saw the stock market suffer in isolation, without the before or after parts, we can become pretty confused indeed. If we really want to manage these things, we can simply choose to pay attention and act when the need arises, but if it turns out that this doesn’t even matter to being well ahead over these dilutive approaches people use, we are making a big mistake without question.

There are all sorts of other misconceptions about bonds out there besides the illusion that it manages risk positively with stocks, although it’s important to note that the very nature of the underperformance of bonds introduces much more risk to even completely unmanaged stock positions.

Bonds themselves can be pretty risky at times, as much as people pretend that they aren’t. It’s pretty easy to come to the view that bonds are always very low risk if you just pretend that this is the case and don’t even bother thinking about this at all, and that’s what people do.

In addition to the indignity of the much lower returns that bonds provide overall, there are times where the risk of them losing value does way up, where their paltry but at least positive returns turn negative.

In addition to calculating the normal loss of performance and the normal increase in risk overall that bonds provide to our portfolios, we also need to compare the relative outlook of each to be able to decide between times where holding bonds actually makes sense and when it does not make sense.

We also do not want to be using an index like the S&P 500 as our benchmark, as we instead need to compare bonds with putting our best foot forward, which we also need to be seeking. If we can manage this, we will be on the right track, but if we do not, we just will not be.

As it turned out, stocks in general have not allowed themselves to succumb to all the concerns out there right now, especially the fact that our economy has such a large hole in its hull, and have collected themselves after the initial shock and continue their march forward.

Just as we have an expectation that stocks will go down in times of crisis, we also expect bonds to rise in value during these times, especially if the crisis is an economic one. Even though there are other influences to bond trading besides economic fundamentals, these data do directly affect bond prices to some degree, unlike with stocks.

Inflation is at least calculated into bond yields, where the lower the inflation, the lower the yield will tend to be, and the higher the inflation, the higher the yield may be, to overcome it. That’s not the only thing that matters, but it does weigh in.

Inflation going up is therefore something to be feared, and although inflation is extremely low now as a result of recent events, down to just 0.6%, but that part only gets worse from where we sit right now. Regardless of how long it might take to get up to full speed again, we’ll be picking up speed along the way, and this is something that is bearish for bonds due to its stimulating growth and inflation in turn.

Bonds are rallying a bit now, and while the media is portraying this as a response to the recent economic numbers, none of this is news. The real reason behind this has been the declining U.S. dollar which is making treasuries a better deal in several important countries, and this is also the case with all U.S. denominated assets, including U.S. stocks.

However, bonds have already priced in the full hit of this economic disaster, so we’re really down to having to rely on the dollar weakening to push this bond rally further, which traders who are only looking to stick around for this can make hay with. Given that the pressure is in the wrong direction when the forex benefits go away, with investors along for the ride, this just isn’t a good idea to be on this even if there were not any other things that we could put our money in besides cash.

We’re actually told that bonds are rallying because people are fleeing stocks for the safety of bonds, not noticing that people aren’t actually fleeing stocks right now. The safety of bonds part is also pretty amusing, not realizing how less safe they actually are generally and especially at times like this where they are holding a lot more risk than usual.

Bond markets aren’t driven by fear anywhere near as much as stocks are, but this still plays a role, as does other things like momentum that they also share with stocks. Bonds can be thought of as watered-down version of stocks, being subject to similar forces but in a smaller measure, so we don’t want to understand them just by looking at the numbers, we want to see how they behave as well.

Bond investing in itself is used as a tool to reign in the risk of stock investing, so we owe it to ourselves to actually examine the relative risks of each over time, where we look at drawdowns not statically but dynamically, seeing not only how far they fall but accounting for how far they climb as well.

Together with measuring differences in return over time, this has stocks winning big on not just the performance count but the risk count, where we compare net returns over time at the bottom of these falls to see how something actually manages risk in the real world.

Bonds are always worth watching though, to see if and when they are ready to take a seat in our portfolios, a seat that they must continue to earn to stay in it. It is not that they do so well in times of need, when stocks are headed the wrong way too much, that we even need to bother with them, and we can’t forget that we can just bet the other way with stocks and do far better than bonds could ever do.

It is perfectly natural to be afraid of certain things, but the first step is to acknowledge our fear before we can even set out to understand it better. Some things with investing we need to fear, like putting all your money on the short side of gold when its price is exploding the other way, or holding on to your stocks during a big panic.

We’ll never know the right thing to do unless we are prepared to examine what we are doing and what we may do instead, instead of choosing a mindless approach. This is far too important to take a mindless approach with.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.