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Don't Be Fooled by the "Everything is Awesome" Market

Jun 30, 2014

It's the Everything is Awesome! market.

The Wall Street Journal has a neat graphic showing that for the first half of 2014, it looks like every major kind of financial asset went up: U.S. stocks, foreign stocks, gold, bonds, commodities... The paper reports that this is the first time in 20 years all these indexes have moved up together.

So what's up with all this up?

Ironically, it may be a result of how sluggish the recovery has been. The economy is indeed improving, in large part because not so long ago it could hardly have been much worse. Sometimes when the economy looks strong and stocks are booming, bond investors get worried as they anticipate the Federal Reserve raising interest rates to hold back inflation. (Bonds fall in value when rates rise.) But Fed chair Janet Yellen has been signalling that she still sees plenty of slack in the economy, especially in employment figures, and that the current policy of rock-bottom rates is going to stay in place for a while longer. So that's kept bond markets bullish in step with stocks.

The fact that both bonds and stocks are up this year may also be a coincidence stemming from the fact that, as the Journal notes, fixed-income investors over-corrected in 2013. When then-Fed chair Ben Bernanke began tapering "quantitative easing," markets saw it as a sign that the era of easy Fed policy was coming to an end sooner than expected, and bonds tanked. Values have climbed back since as it's become clear that the Fed may have jumped the gun.

At this point, if you have any contrarian impulses, your Spidey sense is probably tingling. If markets are climbing everywhere, and the mass of investors see only blue skies ahead, that's got to signal impending doom, right? That's not a bad mental reflex, but it can get you into trouble if it leads you to try to time the market's turns, which most investors are terrible at. Here's what I think is a rational way to adjust to an optimist's market:

DO adjust your return expectations.

By many measures, assets look relatively expensive now, and that means they are priced to deliver smaller gains. This is pretty obvious when it comes to bonds, because when they go up in value their yields go down. Right now, a 10-year Treasury is yielding just 2.5%, and that's as good a guide as any to what you can expect to earn on bonds in the coming decade.

The same logic holds true for stocks. With the caveat that stock returns are never as predictable as bond returns, higher stock prices relative to earnings means you should expect to earn less on them in the future. And stocks are richly valued now, as I explain here.

If you have long-run expectations for lower returns, you might not change anything about your portfolio. But you would make your planning assumptions more conservative. That means saving more if you can, or spending less of your savings.

DON'T try to get too fancy.

When the outlook for future returns is low, investors often start "reaching for yield," investing in new kinds of assets which seem to offer better returns. That often means taking on new kinds of risk, too. The trouble is, these risks often aren't apparent to investors. Since new mutual funds designed to take advantage of investors' hunger for yield haven't been around for very long, you can't always see in their records what happens to them in bear markets.

Eric Jacobson, senior bond fund analyst at Morningstar, tells me he's been keeping an eye on the growing group of "unconstrained" or nontraditional bonds funds. These funds use a variety of strategies to try to outdo today's low-yielding government and high-quality corporate bonds. For example, they may stretch into lower-rated or junk bonds. There's nothing inherently wrong with such a strategy. But Jacobson does wonder if all the investors who have poured money into these funds know what they are bargaining for. "There may be more credit risk and market risk than people understand," he says.

When everything is up, new strategies look great. Corrections tend to bring investors back to plain vanilla.

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