2017 was an incredible year for the stock market. Not only did the average value of the stock market companies rise by around 20 per cent, but there were no major price reversals or spikes. Volatility was low, and everybody was happy with their investments.
Then, in February 2018, things started going wrong. The stock market fell by around 10 per cent, spooking investors, and ushering in a new era of dramatic price fluctuations.
Volatility is the enemy of conservative investors. When prices go up and down unpredictably, they get spooked and try to sell. But the majority of the time they sell when the price is down and lose money.
Ray Dalio, the billionaire hedge fund manager and author of the free book Principles, says that he thinks that the bull market in stocks is soon going to come to an end. As the central banks raise interest rates, the appeal of stocks will diminish. Not only will the cost of corporate debt rise, he says, but the return on bonds will also go up, allowing cautious investors to put their money in safer, more predictable assets.
Dalio has so far stepped back from saying that the stock market is in bubble territory. But there’s no doubt that price-earnings ratios are sky-high right now, and only going higher. Some investors argue that this is to be expected because of the incredible profitability of many of the top-performing companies in the index. But others caution and say that the economy just can’t support the level of future profitability that shareholders seem to expect.
In short, the market is priced to perfection.
On the campaign trail in 2016, Donald Trump hinted that he thought that the stock market was in ‘a bubble’ and that it was going to go pop very soon. That hasn’t happened yet, but most financial institutions and market commentators think that a correction is well overdue.
The Allure Of Bonds
Stocks and bonds tend to be inversely correlated. When the price of shares goes up, the price of bonds falls, and vice versa. True, that’s not always what happens. But there are powerful economic forces which make it more likely.
Bonds have been in a bare market for many years now. But they are finally becoming more attractive to investors because of concerns about inflated equity valuations in the stock market. What’s more, bond payments are on the increase. Viderium bond payments, for instance, paid out at a rate of 9.8 per cent. That’s significantly higher than the average return on the FTSE in most decades of the last century.
The Future Of Bonds
The future of bonds is also bright. Central banks know that at some point they are going to have to raise interest rates. Eventually, inflation will pick up — if it hasn’t already — and they will need to make money harder to borrow, forcing it back down again.
When this happens, it’s likely that lending rates will fall back to their historical norms. Currently, rates are sitting at around 1.5 per cent, even for long-term government treasuries. But in the future, according to Morningstar, they will rise to a more normal 4.5 to 5 per cent. When that happens, bond prices will spike as more and more people seek to gain access to these higher returns.
The time to get into bonds, therefore, could be right now. It seems like investors are facing the perfect bond storm: falling equity valuations and rising interest rates. Bonds have almost become a standalone investment, providing the security that people need in a time when the next recession is mathematically imminent.
Bonds Could Still Be Risky
Bonds aren’t necessarily the saviour of investors. For one, the stock market could continue to rise for a decade. Just because bull markets usually last around a decade doesn’t mean that that will be true of the current cycle. We could see a two-decade bull market and depressed bond prices until the end of the 2020s.
Conversely, buying corporate bonds may also result in severe problems for investors if company profitability falls. Many large companies are already sitting on a mountain of debt. If interest rates rise, they may struggle to service interest payments, forcing bond values down and coupon rates up. Even government bonds could be risky if the government decides that it can no longer borrow from the markets to service its debt.
But ultimately, it will probably turn out that people like Dalio are right. It’s just a question of timing: ride out the stock market for a few more months, or get ahead of the game and buy bonds right now?