July 8, 2013

Is a Bubble on the Investing Horizon? Better Protect Clients’ Downside Risk

The current investment landscape reminds me of the late 1990s. At that time a broadly diversified portfolio underperformed. The reason was primarily due to the bubble which was emerging in tech stocks and because so much capital was allocated to this asset class, performance in the other categories was muted. This is typical of bubbles as they are fueled by massive inflows. 

I recall investors saying at the time that value investing was dead and things were going to be very different in the future. However, as we came to realize, markets eventually normalized, value investing again rose to prominence and everybody learned a valuable lesson. Or did we? 

During the years following the tech bubble-burst we had a real estate bubble in which stocks fell hard and fast. It seems bubbles are occurring more frequently in recent history. Are we witnessing another Fed-induced bubble in U.S. stocks? Moreover, if there really is a bubble emerging in the U.S. stock market, it is thus far well disguised as multiples remain low. Is it true that U.S. stocks are the only game in town? 

Bond Funds

Today, we find ourselves at the end of a 30-year bull market in bonds and interest rates have been artificially low for a prolonged period. As bonds continue to mature bond fund managers have been replacing higher-yielding bonds with lower-interest issues. This has caused average yields to fall and is creating an environment for much lower future bond returns. Then, if interest rates continue to rise, we could see some of the worst bond fund returns in the past 50-60 years. YTD we have seen TIPS and emerging market bonds decline sharply and mortgage-backed securities remain weak. In fact, any bond funds with a longer duration and a lower average coupon will get hit the hardest.

Commodities & Stocks

Broad-based commodities have been in a slump for a couple of years now, the victim of a weak global economy. Emerging market stocks have had their time in the sun, but given their high level of risk, if they continue to sell off, it could be very painful for investors. It's possible that European stocks could do okay, but I wouldn't bet on it considering the massive debt and high unemployment that has plagued this region. 

Summary

That leaves U.S. stocks. It also leaves us with a lesson to be heeded: As investors seek the hot sector, if enough money flows into U.S. stocks, it is quite possible another bubble will occur and many investors will suffer. However, with 2008 such a recent memory, I would be surprised if a large bubble were to materialize. I think it's more plausible that a smaller bubble will occur. In any event, I would recommend caution and make sure you protect your downside as much as possible.

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