For quite some time, I've seen a steady flow of financial pundits explaining on business television and in writing that once bond yields start to rise, retail investors will react to the falling values of their bond funds by selling. The same experts often include remarks about that money leaving bonds and finding its way into equities.
Between February 29 and March 14, the 30-year Treasury bond rose nearly 40 basis points, and the iShares Barclays 20+ Year Treasury Bond Fund (TLT) declined 6.31% ($118.42 high on 2/29; $110.95 low on 3/14). The 10-year Treasury note also came close to a rise of 40 basis points during that time, and the iShares Barclays 7-10 year Treasury Bond Fund (IEF) declined 2.76% ($105.53 high on 2/29; $102.62 low on 3/14). When looking at popular measures of the performance of corporate bonds, the investment grade corporate bond ETF, LQD, also declined from its February 29 high to its March 14 low, by 2.89%. Likewise, two popular high-yield corporate bond ETFs, HYG and JNK, declined during the same time period.
Given the declines in the prices of Treasuries and funds that track corporate bonds, the aforementioned pundits will likely be disappointed by the initial reaction of retail investors to rising rates. During the same two weeks referenced above, fund flows into bond mutual funds actually accelerated from the several weeks prior to the rise in benchmark Treasury yields. According to the Investment Company Institute, in the five weeks ending February 29, 2012, flows into long-term bond mutual funds averaged $7.34 billion with the single highest week recorded at $8.106 billion. During the week ending March 7, inflows jumped to $10.743 billion, and the week thereafter, inflows held strong at $9.096 billion.
In addition, beginning with the week ending February 29, total long-term equity mutual fund flows reversed their moderately impressive performance of earlier in the month and experienced three weeks of outflows. The $2.884 billion, $228 million, and $2.571 billion of outflows during those three weeks would have looked even worse were it not for inflows into foreign equity mutual funds during the same time period. In other words, domestic equity mutual funds really got whacked.
After watching their thesis about the wall of cash flowing from money markets into stocks crumble over the past few years (see the Fed's weekly FRB: H.6, Money Stock Measures for updates on money market totals), industry pundits might be wondering how to convince retail investors to move their fixed income holdings into stocks. If yields continue higher over the coming months, we'll have several more data points to help us gauge whether retail investors seeking income are actually applying the popular "buy the dip" mantra and continuing to add to their bond positions rather than paying attention to the mark-to-market value of their initial investments.
We are living in a world in which millions of Americans are nearing retirement and will be living off fixed incomes for many years to come. If yields on Treasuries and corporate bonds do in fact go higher over the coming years, as many seem to think they will, what makes people think investors won't simply add to their fixed income holdings, thereby raising the average yields of their positions? Rising yields might end up having the effect of drawing even more money into bonds at the expense of equities.
So how might retail investors be convinced to start buying more equities? Beyond, of course, fixing the massive structural problems in the U.S. economy, one way might be (gasp!) lower stock prices. This, naturally, does not jibe with history. After all, retail investors are the ones known in the financial industry as the 'dumb money.' They are the ones traditionally buying at market tops and selling at market bottoms. To whom will Wall Street firms sell their profitable equity positions if the 'dumb money' doesn't start chasing the returns of this three-year bull market?
If the Fed wants to keep printing money as a means of driving all asset prices higher (stocks, bonds, commodities, etc.), why should retail investors allocate any money to the S&P 500 (SPY) or Dow Jones Industrial Average (DIA)? Under that scenario, it might be more enticing to purchase gold (GLD), silver (SLV), oil (USO), corn, soybeans, or wheat (DBA). Furthermore, if Europe is on a multi-year path of austerity, putting deflationary pressure on the interconnected global economy, again, what would make retail investors, as a collective whole, want to purchase the S&P 500 or Dow 30 over, say, fixed income?
In a world in which strong cases can be made for both extreme inflation as well as deflationary outcomes, I can think of plenty of reasons to first allocate money to gold or silver and fixed income, leaving equities as only a secondary thought. If people want to change this and drive equities to the forefront of all investors' minds, perhaps lower equity prices are a better way to accomplish this rather than continually referencing historically low market-wide price-to-earnings ratios as stocks move higher.
The same pundits that tell us the market is cheap from a historical perspective seem to forget what it says in the fine print of their own financial literature, which states something to the effect of, "Past performance is not indicative of future results." After two brutal bear markets in the S&P 500 and Dow 30 and a total collapse in the Nasdaq (QQQ) over a period of just eight years, perhaps the retail investor has had enough of chasing performance in Wall Street's favorite asset to pump: stocks.
We now live in a financial world of markets dominated by high-frequency trading, hedge funds focused on short-term performance, and easy access for everyone to invest in the very things whose prices have the ability to crush corporate profits going forward: commodities. Instead of investing in a stock market that takes the stairs up and the elevator down, perhaps retail investors are simply waiting for a prolonged period of consolidation at lower prices-prices at which people will feel more comfortable buying out of a belief, whether right or wrong, that massive declines are less likely to be on the horizon.
Additional disclosure: I am long many individual stocks and bonds. I am long gold and silver.