Don't Get Burned by Risk—or Bonds

11/09/2009 12:00 pm EST

Focus: MARKETS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener, editor of The Independent Adviser for Vanguard Investors, notes a shift toward higher-quality stocks and warns bond buyers against complacency.

Despite all the ghoulish predictions for October, the month was neither trick nor treat. Investors on a sugar high battled with those that hadn't yet drunk the recovery Kool-Aid, and in the end they came to a draw. The Dow Jones Industrial Average surged over 10000 mid-month, but the line was only briefly held. The index fell back, ending the month flat, while the S&P 500 index fell 2.0%. That bastion of smaller, riskier fare, the Russell 2000 index, declined 6.9% as fear overtook greed on Wall Street. In between, energy and consumer staples stocks were up, while telecoms and financials (the recent rally's darlings) were down.

Earnings reports for the third quarter were a treat—but they may have actually been a bit too sweet. Robust earnings gains shined a spotlight on the severe lack of advance in revenues. While managers managed the bottom line, they've had little success building the top line as joblessness continues to grow and consumer incomes have remained flat.

In response, maybe, the "risk trade" seems to be ending as investors have begun to consider whether a 57% recovery off the low is enough for now, or whether they should continue to push aggressively ahead. For all the back and forth in the stock market, long-bond prices fell in October and the yield curve is steeper now than it's been since May, suggesting that bond investors, en masse, believe a recovery and higher inflation are in the cards.

As for the stock market, I don't think the end is nigh, but I do think there's a change afoot.

What I think we're seeing is a shift to higher-quality companies as investors focus on risk as well as return.

I might also note that for all the anxiety on Wall Street over what Washington will, or won't, do with health reform, my call to remain calm and view our investments in health care as a solid and shock-absorbing piece of our portfolios was proven right in October.

November brings a host of what might be called "stimulus-free" economic reports, wherein we'll get a read on just how the underlying economy is faring without some of the most generous of federal aid programs. An early read was encouraging on at least one front. As October ended, a survey of businesses in the Midwest indicated that manufacturing had a very good month, beating estimates significantly.

Whether this trend holds across the country remains to be seen.

Investors have been pumping a lot of cash into the market—but it's been the bond market more than the stock market of late. I would guess there's a fair amount of yield-chasing going on as money fund rates remain at or near zero in many cases. If you're one of the chasers, please be cautious. I'd encourage you to keep maturities shorter, rather than longer, rather than pushing too far out on the yield curve for a quick pick-me-up. Unless this nascent recovery goes back into the dumps, the Fed will have to raise rates sooner rather than later, and this could be the first shoe to drop on the two-decade bull market in bonds. You don't want to be caught long.

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