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Given how markets are prone to disappoint the prevailing consensus, I was struck by the potential for this sort of logic to be turned on its ear. Today, we see investors running out of the bond markets in droves - almost as fast as the herd ran into it. The bond bandwagon had become too crowded, and in the financial markets, the crowded trade is often the one that feels the most comfortable but can turn out to be the most dangerous.

However, as recent events in the bond market have proven, investors who have been plowing into bonds for fear of deflation and the potential of a double dip recession, things could not have turned out any worse. It seems as if Santa has left coal in the stocking of bond investors. Within the last 90 days, bond prices have fallen enough that it will take close to two years' worth of income from those bonds to offset the decline in the value of the bonds.

The lesson being forced upon investors is that even "safe" investments can be risky if they are overpriced. Bonds had become overpriced. Investment flows into bonds at the expense of equities was so overwhelming that the words "tidal wave" come to mind.


US Dollar vs EAFE index

(Data Source: StockCharts.com)

It is estimated that the money rushing into bonds as a result of investor fears and memories of the financial crisis rivaled that of the mad dash into Internet stocks during the tech bubble. It is an amazing illustration that both fear (running into bonds) and greed (piling into massively overvalued Internet stocks) can both be costly to investor portfolios.

It is hard to say what the U.S. Federal Reserve thinks about this. On one hand, the hundreds of billions of dollars of bonds that they own have taken a substantial dive in a very short amount of time. In addition, mortgage rates have responded by rising quickly. Yet it was just a few months ago that the Fed's quantitative easing policy was announced, in which it was going to purchase about $600 billion of bonds to keep interest rates down to help the economy.

As investors have come to realize that perhaps the economy is stable and righting itself slowly but surely, confidence has risen and investors have become more comfortable with selling their safe assets (bonds) for higher return assets (stocks). Throw in the Fed's resolve to spare no effort to help the economy and the supposed safety of bonds does not look so appealing anymore.

In the short term, perhaps bond prices have fallen too far, too fast. From a historical perspective, the chart above shows that bonds have been in a long secular bull market, stretching almost 30 years; as a result, interest rates have been on a long, gradual downward trend. But if the grand old bond bull is tired and giving way to the bear for the next long-term trend in bonds, investors might want to interpret recent events as a shot across the bow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Source: Bond Investors Receive Coal in Their Stockings