The analyst and talking heads are continuing to expound on the current risk of the markets. Stocks are overbought, they say. We have come too far, too fast, they say. Bonds are in a bubble and prices are ready to pop (move lower as yields move higher). The talk about market risk is being raised continually. Putting this in term we can understand, they are talking about how much downside movement is there potentially in the market if unfavorable conditions arise. One way to look at it would be the potential for the S&P 500 Index to fall back to the 200 day moving average. That would be 187 points from Monday’s close or roughly 11.2%. If stocks are overbought or overvalued we should have a plan to do something to protect our money in the event this downside occurs. Simply put, that is called money management, or for the mathematicians, boolean logic. If this… then that…. For example, if the S&P 500 index were to drop below 1600 currently, sell stocks and hold cash or bonds. And if the index moves back above the 1635 level we will buy the index back. In other words, we would have a plan for getting out of the market along with a strategy for get back into the market. Money management is having a plan in advance of events taking place so we know how to respond or act.
There is plenty of rambling about a bond bubble as well. We started the year with the threat of the great bond rotation which based on the research has yet to emerge or happen. The question still looms… is there a bubble in the bond market? It would be easy to say yes, but the reality is no, not as long as the Fed remains engaged in quantitative easing. The Fed owns trillions of dollars of the US debt with the biggest concentration being at the long end of the yield curve. One firm reported that the Fed owns approximately 40% of the 30 year bonds. With this unprecedented holding of treasury bonds by the Fed you can understand why the bond bubble has not emerged. How will it all play out? That is the trillion dollar question that many are speculating on. TBT, ProShares UltraShort 20+ Year Treasury Bond ETF has jumped 12% the last two weeks as yields have moved up to 3.17% on the thirty year bond. How much higher will yields climb near term? 3.25% was the high in March and would be the short term target currently. Thus, the bubble isn’t showing any sign of popping near term, and it still begs the question if a bubble really exists at all. Bubbles occur when too much money is pushing prices up unrealistically. The money pushing treasury bonds is coming from the Fed? Will they dump them unrealistically? Again, watch, have an exit strategy and keep looking forward.
All of this begs the question, why own bonds to start with? Early in my career I was taught that bonds are a hedge against bad investment decisions. The psychology of investing is based on an investor understanding their risk tolerance or the ability to withstand volatile periods or market cycles. In other words, owning bonds in a portfolio keeps you from putting the money at too much risk relative to the overall market allocation. This is the psychological risk of the investor being overexposed to stocks in their portfolio. Greed during a strong uptrend tends to increase the risk an investor will take on because they want to maximize returns, and thus the psychological risk is expanded. I call it the bulletproof mentality or I can do no wrong. Therefore, with all that can potentially go wrong with bonds they do offer a buffer for investor behavior towards their portfolio. A laddered portfolio of bonds held to maturity avoids the issue of principle fluctuation. But, if you don’t want to build a ladder bond portfolio, remember that cash is a sector and when bonds start to erode in value, a shift to cash prevents the downside participation. You can always buy back into bonds as rates settle or normal conditions return.
All of this talk about what will or may happen going forward is just that… talk. We can play what if scenarios all we want, but the important thing is to have a plan of action that will take place if certain events happen in the stock or bond market. Money management is about being proactive not reactive towards you portfolio. Always plan and act based on your strategy developed in advance of the events.