The idea that financial markets will go into another freefall like the one that hit in 2008 has never been entirely left behind by many investors. It's one of the reasons a lot of them missed the current stock rally and stuck with bonds.
Now bonds, too, are being talked about as a risky bubble that will pop as soon as the Federal Reserve hikes interest rates. Meanwhile, in 2013, stocks are seeing the biggest gains in years. What's an investor supposed to do? It's not exactly "Don't Worry, Be Happy" time. But too much fear can be counterproductive.
Investors should start by reviewing all of those dire warnings. They can't all be true. It's never foolish to keep a dose of healthy skepticism. But it's hard to support the view that financial assets are totally unhinged from the "real" economy. Here are a dozen reasons why stocks and bonds are not bubbles waiting to burst (along with some reasons analysts and fund managers say there could still be trouble, even if there is no bubble).
1. Crashes don't come when people expect them. Back in August 2008, there was not much talk of stocks being vulnerable. Google Trends shows that the search terms "stock bubble" and "stock crash" fell to the lowest level in the nearly five years the month before the crash. They've risen steadily this year. But search traffic is one thing. Valuations are another. And those could be high. Bond yields are near all-time lows, not even covering the cost of inflation. Stocks are close to their average based on underlying earnings. "The case for a bubble in the bond market is a strong one. The case for a bubble in the stock market is not a strong one," says Hugh Johnson of Hugh Johnson Advisors. "The real question: Can the Fed let the air out of the bond market in a way that bond-market trading remains orderly?"
[Read: Here's Why Diversification Matters.]
2. Stocks and bonds rarely, if ever, fall dramatically at the same time. In the 2008 crash, bonds prices soared, helping markets stabilize. The chance of a "double bubble" is highly unlikely. Unless, of course, this time is different. The threat is that stocks are getting all the investor attention simply because there's no other good option. "Bullish people have been looking at equities in relationship to Treasurys, with their low historical rates. When those go up ... that narrative falls apart," says James C. Roumell, president and portfolio manager at Roumell Asset Management.
3. Markets have been letting off steam, especially in bond markets where a Fed rate hike is widely anticipated. The key 10-year Treasury note fell 25 percent in price last month as its yield jumped 50 basis points (half a percentage point). Prices move inverse to yield. But bond investors, not a nimble bunch, may simply be holding on out of necessity or habit. "A lot of people still own bonds because they still think they are safe. Sometimes because of investment policy for a fund or institution, they can't get out," says Mark Germain, chief executive officer of Beacon Wealth Management.
4. The "panic buying" rallies of past market bubbles have not been seen. Stocks have gained steadily, but not in leaps. The first trading day this year saw a 300-point Dow rally of 2.35 percent - still the year's top gain, but nowhere in the top 50 one-day percentage gains. But just because it hasn't happened doesn't mean investors have become more rational. "If the people on the sidelines suddenly jumped into the market, it could hurt a lot. Panic buying would be a bad thing with a market already overvalued about 10 percent," says David Edwards, president of Heron Financial Group.
5. The fear of a "bond bubble" is based partly on a misconception that people hold massive amounts of highly interest-rate sensitive long bonds. But Treasury data shows that the average debt maturity is just over five years. In recent years, the Fed has been mopping up long bonds, and few have been issued. That's not to say higher rates won't be tough to navigate. Rate rises would slam wide sectors of the economy, including mortgages. "Fixed-income bonds yields have been low for so long ... the mindset is still burned in," says Brian Levitt, chief economist of OppenheimerFunds. When the Fed finally lifts short-term rates, it will have an impact on a wide range of borrowing costs.
6. The housing market is improving. It's a key to stability since it was the cause of the last crash, and its plunge created a perfect storm that froze credit markets and hammered consumer confidence. The bad news is that weak spots remain in real estate. "The housing recovery is not complete," said David Blitzer, chairman of the index committee at S&P Dow Jones Indices when recent home data was announced. Foreclosures remain high, and mortgage rates are going up.
[Pimco's El-Erian: Why 'Zombies Threaten Markets.]
7. Exchange-traded funds include fixed-income offerings that can be "laddered" with short- and long-term debt and other products to result in less volatility for income investors, making it possible for individuals to diversify yields by using low-fee funds. S&P Capital IQ says there is $250 billion invested in fixed-income ETF funds. Half of the funds S&P covers are less than three years old. Investors have shown strong demand for new offerings like the iSharesBond 2016 Investment Grade Corporate Bond ETF, launched in April, and PowerShares Global Select Short Term Bond Portfolio, filed in March. A less conservative move, but one that could pay off if rates rise, are new funds like the ProShares High Yield-Interest Rate Hedged ETF, which is made up of high-yield, short-term debt mixed with Treasury futures designed to gain value as rates rise. In addition, investors already have put more money into floating-rate bank funds than they did during all of last year, according to Lipper.
8. Stock valuations are near historically normal levels based on earnings, which are likely to grow in the stronger economy. The Fed insists it will not boost rates until a recovery has been confirmed. But there may be room to doubt outsized earnings growth. Corporate sales are not rising. "It is not often mentioned that companies are benefiting from operating [profit] margins that are near the highest in history," says fund manager Roumell. The recent years of low rates and hiring cutbacks have created easy profits that will not continue. "If you look at it this way, stocks are a lot more expensive," he says.
9. Fund managers have been aggressively buying low duration (short-term) bonds to fill income needs, which will lessen the impact. The funds will attract new buyers with higher yields when rates rise. That might support the market, but it doesn't mean bond fund investors will reap the benefits. In fact, they should beware of sticker shock. Financial Industry Regulatory Authority Chairman Richard Ketchum recently warned financial advisers to "remind clients that bond funds are not the same as directly owning fixed securities - if the market moves, losses will occur instantaneously and there will be no ability to hold a bond to maturity."
10. Mutual funds that invest in stocks and bonds, like target-date or balanced funds, have reduced exposure to long-term fixed-income debt to soften the impact of rate rises on widely held retirement funds. No downside to caution here.
11. Income investors have shifted into dividend stocks, floating-rate funds and real estate investment trusts, which can raise dividends as interest rates rise and inflation increases, or high-yield bonds that do better in a stronger economy. As investors diversify income holdings, the market is vulnerable to a bond crash.
12. Moderate growth and inflation will help the stock market, and a moderate rise in interest rates will help savers. In "the post-crisis way of thinking," people have been "reluctant to embrace views of modest growth and inflation" even though "it's what we now have," Levitt says. On that front, at least, things may really be better than we think.