Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

The equity boom that extended from 1982 to 2000 is losing both long-term investors and the cult following that developed from 1996 to 1999. Every equity investor was a winner during that latter, “manic phase,” and it captured the imagination of career professionals and homemakers alike. Everyone was “in” the market, many abandoning day jobs for the life of a day trader. Everyone was “in the market,” even past the point of prudence, and losses quickly multiplied in the place of gains.

Characteristic of the equity cult following were the deeply held convictions of the investor class – unable or unwilling to take a more objective view of the extreme overvaluation in that market. Sincerity of belief was thought to be enough.

Unfortunately, reality broke in. As the stock market began to deteriorate and become a professional’s game again, people quit looking at their statements and instead began comparing home values in the neighborhood to see where they could conjure a bit of mirth.

The cult-like followers of the stock market have had their beliefs challenged, and now, after 10 years of minimal to negative returns in equities, we are witnessing a quiet migration out of that asset class. Enthusiasm is muted (except for Cramer, and we keep him muted for sanity’s sake), CNBC viewership remains in decline, and hope is dwindling – to be replaced by disillusionment and ultimately fear. The market is now ripe for capitulation as the sentiment holding it together is weakening by the day. Liquidity injections aside, the markets are very weak.

But of note to us is the migration that has occurred over the past two years. As traders struggle to wear the happy face, and investors scratch their heads, unable to understand the course the market is on, they are all moving from stocks to bonds.

So the latest cult following is in the bond market. The trickle from the stock market into bonds has become a flood. The bond market is seeing investor interest rise to levels beyond the hype and manic inflows of the equity crowd in 2000 (just over $300 billion in inflows at the peak). Those funds are now the discouraged inflows (into bonds) of the middle class – who do not hold their bonds directly, but through the middle class investment vehicle of choice: mutual funds.

Here you see a no-vote on the stock market, and a well-trained response (unfortunately superficial) that views bonds or fixed income as a safer alternative to the risky and reward-lacking stock market. During 2009, close to $400 billion moved into bond mutual funds; 2010 is on track for similar figures.

These investors are unaware that bonds are now in the most manic state of the last 30 years. That’s not to say bonds can’t move higher as more lemmings pile in; we expect a final move above the 2008 panic purchases by this fall. However, the value of a bond is tied directly to the interest earned on it. As rates are lowered, the price of the bond goes up – but you can only take rates to zero. Doesn’t that put an ultimate cap on the price, and therefore the potential gains? We are nearly there.

Theoretically, people will subject themselves to financial oppression by accepting negative rates, but that is rarely tolerable for any length of time (weeks to months). When faced with this “opportunity,” people generally opt out of the markets altogether and favor investments such as gold. When considering the fixed income world, particularly Treasuries, it seems a bad bet when your potential profit is 10-15% at most, and your potential loss is 60-70%. Still, the cult following grows.

The bond bull market is 28 years old, running in sync with the decline in rates that started in 1982. This bond bull market ran parallel to the stock bull market with the same inception date, and has now extended further as rates have been lowered to accommodate an ailing economy and frustrated market place.

Where do we go from here? Artificially low interest rates ultimately lead to significantly higher interest rates (Knut Wicksell’s work over a hundred years ago proved this, and has never been successfully challenged). This will translate into significant losses for investors who have again stopped looking at portfolio statements – either because nothing ever happens or because, when it does, it’s too painful to reckon with.

I doubt that homemakers and career professionals will be leaving their day jobs to trade bonds (very seriously doubt that), but as they grow weary of the perpetual sideways grind in the equity markets, the 2, 3, 5, 7% returns in high-yield corporate and junk issues will look more and more alluring. The cult following will grow. The bull market, already a bubble, will eventually burst.

Despite all that, in their unfailing sincerity of belief, investors will continue to struggle with the idea that “surely bonds are a better bet than stocks.”

Will it take just as long for bond holders to acknowledge change in their market as it has stock holders in theirs? What losses will be required to change their minds? How long will it take?

When we wrestle with the rationality or irrationality of the investing public, it is helpful to remember G.K. Chesterton’s adage, “you cannot reason someone out of something they didn’t reason themselves into in the first place.”

Enjoy your long weekend!

David Burgess
VP Investment Management

David McAlvany
President and CEO