First we had the tulip bubble in Holland, and more recently we had the tech bubble, followed shortly thereafter by the housing bubble, and now, we have the bond bubble.
Throughout the duration of each, denial was rampant, yet each previous mania ended with blood in the streets. Most professional investors are fairly sure that the current bond bonanza will follow suit.
Decision making by individual investors is again going in the wrong direction, and may indeed have disastrous consequences. For the 12th week in a row, small investors have taken money out of stock and hybrid funds and poured it into bond funds.
"Why not?" say the naéØve participants. "Bonds are a lot safer than stocks."
Sorry folks — wrong again. By taking a little trip in the way back machine, we can examine the herd behavior of individual investors and why their conclusion about bonds' safety is fraught with peril.
Most of us remember the tech bubble, which was largely propelled by the explosion of the Internet. Dot coms were everywhere, and individuals thought that just because the Internet was here to stay, Internet stocks had to climb forever.
They forgot about one important thing — profits. Most of the dot coms would never make a profit, and each would run out of money at some point. When the money was gone, so were the stocks. Even though it seems so obvious now, it certainly wasn't apparent to most during the late 1990s.
For generations, most people regarded their homes as a great investment, yet the facts belie that theory. Residential real estate has been a mediocre investment for much of the last three decades. Even commercial real estate has returned less than half of the Standard and Poor's 500, yet the myth prevails.
Why? Because people want to believe it. The housing bubble was created by cheap credit, low or no credit standards and rampant overbuilding, particularly in warm weather areas. Mortgages were given to low income people out of some idealistic notion that every family deserved to own a home.
We know how that worked out. Builders and contractors continued to build vast developments even as the signs were obvious that it was a very bad idea. Why did they continue? Because, as one builder told me, build is what they do, never letting the facts get in the way of a good mission. In many areas, housing prices are down more than 50 percent. If that's not a burst bubble, I don't know what is. That brings us to our current bubble.
Bonds are borrowings from states, cities, the federal government and corporations. Generally speaking, they pay a stated interest rate until the bond matures. While some bonds are for a short term, others are for 30 years or even more, yet the critical element is that almost all bonds pay interest rates that do not change.
In a time of declining interest rates, old bonds may be better than new ones, and therefore are worth more because they pay higher interest. But in a time of rising interest rates, old bonds are stuck with their lower payout, and therefore become worth less and less.
Think about it. Interest rates have come down to zero over the past 30 years. What are the chances they can repeat that performance? Also zero. They can't go anywhere but up, and that will devastate the values of all these trillions of bonds being bought today. By the time most bond holders figure out what is happening, it will be too late. It's just math.
In last week's "The Economist," the author posits that "a lot has to go wrong to justify today's rock bottom bond yields," referring to the almost Armageddon like scenario necessary for rates to stay this low. While he says there is "a bull market in pessimism," anyone with an intact memory knows how fast moods can change. Most of the remarkable drop in core inflation has been because of falling rents. Nationally, rents are again rising as apartment vacancy rates decline, and that will soon lead to rising inflation numbers. When those inflation figures start to rise, watch out for bonds.
Individual investors are prone to make bad timing decisions, and thus subject themselves to low returns. Dalbar, the Boston based financial research firm, recently updated its study on individual investor behavior. It showed that for the 20-year period ending December 2008, while the Standard and Poor's 500 returned 8.35 percent per year, individual investors got just 1.87 percent. John Bogle, the founder of The Vanguard Funds, published a study that showed that individual investors underperformed the S&P 500 by 45 percent.
Most of the reason for the disparity was bad decision making as to timing. How will the devotees of "safe bonds" fare when the winds change? Not well, I'm afraid.
• • •
William T. Ryan is president of Ryan Financial Advisors in Andover. His column appears each week in the Sunday Eagle-Tribune. Reach him at 978-475-1500 or by e-mail at wtryan@ryanfinancial.com.
