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Demystify graphicThe sudden increase of flows into U.S. stock mutual funds is producing articles warning that investors are once again chasing performance -- and that's a danger sign. It seems plausible, now that the market is at all-time high levels and up 100%.

But is that really all there is to it? A 3 year, 9 month wake up call to buy stocks? Let's start with that 100% return. Note (in graph below) that fully half of it occurred in the 2009 rebound period. Very typical investor behavior after a serious drop with massive uncertainty (and fears) swirling about is to "wait until the dust settles." While a contrarian approach certainly would have produced the best returns, few non-professional investors are capable of jumping into such an intimidating market.

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Stocks vs bonds from market bottom

(Stock charts courtesy of StockCharts.com)

Note: Three ETFs are used in these graphs to show the total return earned by investors in the indexes chosen, including dividends and interest (less expenses).

  • SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) - Index = Dow Jones Industrial Average; $11 billion in assets; 0.16% expense ratio. (This remains the most popular U.S. stock market measure among investors.)
  • iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG) - Index = Barclays Capital U.S. Aggregate Bond Index; $15 billion in assets; 0.15% expense ratio. (All U.S. bonds, including those that ran into trouble during the financial crisis.)
  • iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT) - Index = Barclays Capital U.S. 20+ Year Treasury Bond Index; $3 billion in assets; 0.15% expense ratio. (A pure view of U.S. Treasury bond returns, made especially visible by focusing on those with the longest maturities.)

So, let's toss out the 2009 rebound and concentrate on the 3-year period, 2010 through 2012.

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Stocks vs bonds 2010 - 2012

This typical performance interval, while showing better cumulative stock performance, also reveals distinct, sharp stock market drops. Importantly, a frightening, mega-fear environment accompanied each drop. Now, look at those bond returns: nice and steady -- a haven from the storms. Therefore, investors continued to view bonds favorably (the perfect antidote for worry and uncertainty) regardless of stocks' widening performance edge.

But there's more to the story, and, for that, we need to look back 7 years (2006 through 2012).

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Stocks vs bonds 2006 - 2012

"Normality" existed in 2006, with stocks back in portfolios after the 2003 Internet bubble nadir. Risk investing was in the air, and expectations were being filled: more risk = more return. Underneath, the housing/subprime bubbles formed, leading to the 2007-2008 rollover and descent into the Great Recession and financial crisis.

Now, let's look at key developments and a pattern that emerged and reinforced investors' preferences.

First, take a look at year-end 2008. Parts of the bond market were freezing up as downgrades proliferated and pricing + trading disappeared. The climax came as the overall bond market swooned, along with stocks. Only U.S. Treasury securities were viewed as safe, as shown by the divergent performance of AGG and TLT. Lesson #1 learned: Safety first.

Second, as the bond market began to heal, the stock market hit bottom, then performed its 2009 rebound. However, the bad news continued to roll in, so bonds retained their preferred status.

Third, early 2010 saw signs of progress and improvement, and there was the beginning of growing interest in stocks. However, the first mega-fear period hit with not only warnings of potential reversals, but also visions of catastrophe and collapse. As the stock market plummeted, the bond market rose. Lesson #2 learned: Safety first reconfirmed -- plus bonds were the smart investment, providing positive returns in worrisome times.

Fourth, the 2010 stock market reversed its drop and surpassed its previous high. Therefore, a burgeoning interest in stocks began to rebuild in early 2011, growing as the months went by. Then, once again, the mega-fear environment returned with more warnings and terrible visions. Stocks dropped and -- voila! -- bonds rose. Lesson #3 learned: Remember lessons #1 and #2!

Fifth, although the 2011 stock market reversed that drop and rose higher, any interest in stocks was dampened by an early 2012 drop. There was a difference this time, however. There were fewer warnings and the visions weren't as scary, so the market soon reversed and climbed anew. However, even that drop kept up the pattern of producing a bond rise. Therefore, while stocks clearly were outpacing bonds, there still was little impetus to forget the previous lessons.

Sixth, the stock market had a mild drop in the fall of 2012. Note the key difference this time, however: Bonds didn't rise much. Not exactly a lesson learned, but with the stock market's subsequent move towards the 2007 highs, it laid the groundwork for a rekindling of interest in stocks. Throw in the steady flow of good news towards the end of 2012 and continuing into 2013, with the stock market staying on course, and it began to feel that maybe those bad, old days were passing. Combined with the lackluster bond performance and the growing warnings of "Watch out! The Great Rotation [from bonds to stocks] is coming!" the incentive to consider stocks grew stronger.

And that's where we sit today: Bonds waffling and stocks rising. After those two, milder 2012 drops and, particularly, the failure of bonds to rise during the second one, investors may be willing to forego those previous lessons. The real catalyst would be a return of optimism (see Optimism's Re-Emergence Could Shake Up 2013's Performance), the normal ingredient in a bull market.

The Bottom Line

Investors' multi-year preference of bonds over stocks was neither simplistic nor stupid. It was built, first, from a new, negative reality. Bond investing was the chosen strategy, and that approach was supported by a subsequent, repeating pattern of fears + stock drop = bond rise.

Now, it appears investors are willing to shift gears. The need for a bad times haven is giving way to a desire for good times return. That's a healthy step, and a logical extension of their investment process.

Source: Demystifying Investors' Preference For Bonds And Why It Could Be Changing