While investors often use bonds and gold to hedge against stock market plunges, all three assets going up at the same time is leaving some of them quite confused.
In spite of all the talk that we’ve heard about the 10-year bull market with stocks coming to an end, it just has kept going, with all-time highs being reached last Thursday. When you just hit an all-time high, things can’t be running so badly.
Investors have been anxious about the economy, but while the forecasts that we have now do have things slowing down a little, they are coming to finally realize that the course that we’re on isn’t so bad after all, and the Fed is waiting in the wings should they be needed to boost things up a little.
The Fed’s recent message that they have our back and are committed to the nice and steady growth that we have enjoyed lately should not have come as any surprise to anyone really, because this is part of the mission of the Fed. There are times when they clearly seek to dampen growth but only when needed, and, unlike last year, we’re not in one of these scenarios.
We’re actually on a nice, even keel right now, which might be moving a little down but still leaving us within the comfortable range. The current trend does indicate that we will see a rate cut next year perhaps, when things slow down a little more, but if the forecasts are off and we do get there this year, we’ll get the cut this year.
If we do see an improvement in relations with China, where we not only lose the current tariffs but broaden trade between the world’s two largest economies, this actually will counterbalance the current slight trend down in the economy and this can even take the place of these expected rate cuts down the road.
Meanwhile, the current tariffs aren’t really putting much of a damper on things and as long as they aren’t escalated, they are fine. The market was a little afraid of their effects during the month of May, but we’ve already put that to rest and have already gained all of the ground that was lost and have even moved a hair past that.
We are at a point of resistance though, where things stalled at the end of April, and in the short term we do need to pay attention to what happens over the next week or two, which will tell us whether we really are going to go higher or stall once again right here. If this is the top again for now, we at least have the comfort of knowing that the market is more optimistic at least then when it drove us 6% lower last month and the expectation would be that any pullback right now would be of a lesser extent.
The Confusion Surrounding Bull and Bear Markets with Bonds
As people start to get uncomfortable with their stock positions, they tend to move more into bonds, but the bond market being as hot as it is actually an obstacle to too much of this.
Those who have held bonds through their run up are no doubt pretty happy as they have made some pretty nice money lately, nice at least compared to how bonds normally perform. We hear that bond yields keep going down and down and that might seem to suggest that bonds are behaving bearishly, but nothing could be further from the truth.
Bond investors or anyone who is looking to add bonds to their portfolio, particularly U.S. treasuries, will be turned off by these lower yields, and as long as the stock market is moving up, more of this money will be put in stocks that would have otherwise moved to bonds if the time was right and they were paying more.
Many people worried about the bond rally bringing down the stock market, but while the stock market selling off can boost bond prices and lower yields, bond prices going up and yields going down in itself does not contribute to people selling off stocks and this is something that supports stock prices in fact.
When stocks go down in the face of rising interest rates, now bond yields are more generous and it becomes a lot easier to move into them. A lot of people don’t really understand that a lot of this is a wash though, with higher yields and higher interest rates going hand in hand, along with higher inflation which makes the overall situation quite similar to lower yields, lower interest rates, and lower inflation.
All bonds really do basically is hedge inflation, from a return perspective anyway. However, their prices do move up and down and we can use this to our advantage.
If the bond prices are moving up and we’re not so committed to holding them to maturity, this offers us the chance to speculate on their price, buying now for instance and selling later at higher prices once this bullish run starts to wane and prices start to back up again.
When we see yields go up and up, it’s actually better not to be in bonds during this time if you are thinking that you want to or may need to sell them prior to maturity. In this situation, this is a lot like wanting to buy a stock that is going down because you are hoping for higher dividends. When you sell a bond at quite a bit less than you paid for it, which happens during bearish bond markets, this is at least a mistake over holding cash.
If your stocks are going down and your bonds are going down too, we might think that we are fortunate that a certain portion of our portfolio is hedged by bonds, the fact that all we’ve done is add further to our mark-to-market losses should not be something to take comfort in and it should make not happier but less happy.
We think that we need to have our money invested somewhere though, and those who sell investments aren’t going to do much to dispel this thinking, as whatever portion of our portfolio that is in cash risks their funds managed going down. These people don’t care what we invest in as long as we do invest it with them and preferably all of it.
Many people don’t really understand what a bullish bond market is though, because they don’t really understand which side runs with the bulls, price or yield. It is price of course, and the only reason that yields go down when bonds go up is that the interest paid on them represents a lesser and lesser proportion of the price, just like dividends can get diluted as a percentage of the stock price when a company’s stock rises quite a bit.
It Is All About Having our Money in the Right Places
If we are thinking of moving some or more of our portfolio into bonds, a rising bond market should excite us, not scare us away. It’s not that there really is a reason to do that now though, in the face of our stock market gains so far this year, which continues to trend upward, but if we did, and bonds were going down not up, this is what should scare us.
If we bought bonds last fall when stocks were really dropping, say in early November when the yield on the two-year treasury was 2.98%, we would have been watching the increase in value all the way to today, where it sets at only 1.77%, a big drop in just a little over 6 months.
This would be a great trade as far as bond trades go, not in spite of declining yields but because of them. It is therefore pretty important to have at least this basic of an understanding of bonds prior to investing them, and if we don’t understand why bonds have gotten two thumbs up over the last while, we have some learning to do.
Bonds can enjoy momentum the same way that stocks can, and this hammering of yields with bonds represents a surge upward that can sustain itself to some degree. Bonds don’t move anything like stocks do though, and at best we’re shooting for relatively small returns here compared to a bull stock market, but that sure beats losing money on stocks. It’s important to get the timing of this right though.
There is also an interplay between gold and bonds, and in this case, the overflow from the demand in the bond market is spilling over to the gold market as well. Stocks, bonds, and gold are all going up right now, at the same time.
This does suggest that the three aren’t really correlated very strongly with how we think they are correlated, and while this isn’t a significant sample of anything, they really don’t correlate that well one way or another.
Wise investors will view each of these markets independently, and while a fall in stock prices should turn our head more toward bonds or gold, we should never just automatically move our assets over to one or both, as we need to assess the viability of such a move.
While we really could not have gone wrong with any of these three assets since the beginning of June, things go down in price as well. When they do, that’s when we need to question whether we want to stay in something or even get in or add to our positions.
Investing is far simpler than a lot of us believe. It’s about investing in something when its value is appreciating, allowing us to capture that price appreciation, and it is not about being invested in something that is depreciating in a predictable manner. We can’t avoid losses, as this is all about probability and not certainty, jumping on and staying in assets with our eyes fully closed isn’t a good way to achieve our potential.
Hedging our risk is very important, beyond what most investors realize. If we are going to hedge, we need to do so sensibly. This means that we need to prefer to avoid allowing any asset to draw down our portfolio value beyond what cannot be reasonably avoided.
Bonds and gold can provide profitable opportunities at certain times, depending on their markets, but this is not really a hedge, it’s a good use of the money we have already hedged by rescuing it from a sinking ship. If the water rises again, and the risk gets reduced to comfortable levels again, and we can then reassess its desirability, but this sort of assessment needs to be made with all of the investing that we do, and if done right, this should have us hedging this way a lot more than we do.
Hedges like bonds and gold should always be compared to not just the performance of its competing asset, where for instance bonds may go down less than stocks, they need to be compared to cash as well, and cash is always an option at least worth considering.
Cash sometimes beats them all in fact, not so much beating them than having a better outlook than any of them. The wise investor will keep his or her eye on all competing assets, to make sure that they do compete and that we pay attention to the results to help our own results.