U.S. Stocks vs. Bonds: The Obvious Choice

 |  Includes: DIA, IEF, QQQ, SPY, TBF, TBT, TLT
by: John Tobey, CFA

Occasionally (rarely) there are times when the next investment trend is obvious. Today looks like one of those times.

How trend changes can become obvious

These situations happen when two opposing trends occur in tandem:

  1. A popular trend is taken to an extreme high. Extraordinary buying drives prices up as potential returns sink abnormally low. Starting with good past performance, investors and commentators build increasingly flimsy rationale for why this particular trend will continue in spite of the historically weak fundamental basis.
  2. An unpopular trend is taken to an extreme low. Extraordinary selling drives prices down as potential returns (valuations) rise abnormally high. A combination of weak past performance and previous disappointment keeps investors’ and commentators’ viewpoints negative in spite of the historically strong fundamental basis.

These trends can occur between any two investments: asset types, countries, sectors, industries and even individual securities. Importantly, when the dam breaks, the money can rush from the [previously] popular to the [previously] unpopular.

Today’s situation

  1. Popular trend: Bonds. Large buying and over-allocation in portfolios drove yields (potential returns) to historical lows. Investors and commentators continued to make the case for owning bonds.
  2. Unpopular trend: US stocks. Large selling and under-allocation in portfolios drove valuations and dividend yields up. Investors and commentators continued to point out the risks of owning US stocks.

The one picture that tells it all

For the past two years, investors have bought bonds and sold US stocks. (US stock fund selling has now reached 32 consecutive weeks.)

click to enlarge

Click to enlarge

That picture also depicts what institutional investors have been up to. US stocks are greatly underweighted in their portfolios.

What will make the trends change?

This is the key question to many investors. But it is the wrong question. Savvy investors seek to buy when valuations are attractive and sell when potential returns sink. They tend to buy and sell “early” so as not to miss out on the under-priced opportunities or to get caught when over-priced popularity evaporates.

That being said…

It looks like the time is near – even upon us

The Wall Street Journal had an article that summed up the situation perfectly (“Stock Markets Are Poised to Steal the Show Next Year,” Heard on the Street, by Richard Barley, December 22):

The case is simple: Stocks are attractive relative to other asset classes, with cash-rich corporate balance sheets, strong earnings, and global growth looking good. In contrast, after rallying hard in recent years, government bonds are in turmoil, either because of fiscal problems or inflation fears. And much of the juice has been squeezed out of corporate bonds.

Year-end: A time of New Year’s resolutions – and change

This year-end is different from last year’s. Gone are the large economic uncertainties. Now we find investors and commentators focusing on identifying potentially high return investments. Selected US stocks are now being added to the list.

At the same time, the stance on bonds has become neutral – even negative. Concerns include the recent runup in bond yields (drop in bond prices), the ineffectiveness of the Federal Reserve’s bond buying and the rise in commodity prices (inflation worries).

So… These last days of 2010 are a perfect time to evaluate your investment portfolio. The key is to forget the past and focus on the future, potential returns. Today that looks like buying US stocks and selling bonds is a strategy well worth considering – even obvious.

Disclosure: My clients are long US stock and US stock funds