Monday, August 20, 2012

Interest Rates Move Up

One of the most widely held views among elite market observers has been that U.S. Treasury securities will be terrible investments over the next decade.  The explosion of the Federal Reserve's balance sheet--"money printing"according to the Fed's critics--is expected to lead to inflation.  In addition, when the Fed's unprecedentedly loose monetary policy is reversed--presumably when the economy improves--interest rates will rise, and bond prices will fall.

Bonds, especially U.S. Government bonds, have been superb investments for a long time.  Interest rates have been in a declining trend since 1982, which has led to rising bond prices and excellent risk-adjusted returns.  Though bond market cycles historically have been much longer than those of the stock market, the current 30-year bull market in bonds has seemed to many to be on borrowed time.

So it surprised me to notice that the yield on the 10-year Treasury note has risen from a recent, all-time low of 1.4%, to 1.8%.  This move in bond yields was matched by a breakdown in the utility sector of the stock market.  Utility stocks have historically been sensitive to changes in interest rates, but with the sector quite overvalued and now yielding relatively little, perhaps even modest increases in bond yields will cause heavy selling of utility stocks and rotation into other sectors.

Is this the beginning of a bear market in bonds?  If so, it would be a shock to many individual investors, who have shifted many billions of dollars from stocks to bonds in recent years.  I suspect that a financial shock or economic slowing this fall will provide support to bonds.  I do think, though, that the clock is ticking for the bond bull market.  

Does that mean that stocks would have a bull market as funds shift back to stocks?  With U.S. stocks approaching the highest point in the last four years, I'm skeptical.  The S & P 500 Index, for example, is approaching its two prior highs, in 2000 and in 2007, both of which were major tops before brutal declines.  Market sentiment measures seem to optimistic to sustain a strong move higher in stock prices from current levels.

With many stocks up 15-20% in price in the last two months, I strongly urge caution by equity investors.  Now is an excellent time to replenish cash reserves for better future buying opportunities.

Steve Lehman

S & P 500:  1415

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