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The Coming Rush Out of Bonds and Into Stocks

Stocks have hesitated, but bull market boom is near


Over the last week or so, we saw the potentially powerful confirmation of a new long-term trend in the making. After Fed Chairman Ben Bernanke went on 60 Minutes to promise a virtually endless wave of quantitative easing schemes (“whatever it takes”), and then Congress reached a business-favorable tax compromise late Monday, the mega-switch from bonds to stocks took a giant step forward. While the tax bill should boost economic growth, it may widen the deficit, requiring stepped-up offerings of new Treasury bonds. Unfortunately, those new bonds will meet a chilling response from a skeptical world of increasingly wary bond buyers.

Yesterday, for instance, the yield on the 10-year Treasury note rose to 3.29%, a six-month high. The rate was just 2.93% late Monday, before the tax bill was finalized. Then it shot up to 3.13% on Tuesday and 3.29% mid-week. (Higher rates will cost the Treasury more in debt service, thereby boosting the deficit.)

Bonds have been a major magnet for new money over the past two years – until last month. According to the Investment Company Institute (ICI), the weekly net new cash flow to the bond market eclipsed stocks for two years, until the two weeks ending November 23. That’s when the European sovereign debt crisis re-emerged and the U.S. municipal bond market began to fall apart. That’s when California had to postpone some key sales of its municipal debt, and municipal bonds suffered their worst day in two years.

Prior to November, many retired investors had relied on high-yield bonds or tax-free municipal bonds to make ends meet. With T-bills offering less than 1% and 10-year bonds hovering around 3% (with the added danger of price erosion if rates rose), high-yielding bonds tended to be “magnets for mom-and-pop money,” according to Mark Gongloff’s Abreast of the Market column in Monday’s Wall Street Journal. But U.S municipal bond funds lost $7.9 billion in mid-November, in a stampede out of muni-bond funds.

Over the short-run, quantitative easing has contained long-term rates, but over the long-term, easy money policies will create more bond volume, meeting slack demand, causing long-term rates to rise and bond prices to fall. Corporations have far cleaner balance sheets than most governments. With their trillions of dollars in cash, plus earnings rising at record rates, corporate stocks and bonds look more attractive than government-funded promises, with their huge budget deficits and continual debasing of their currencies.

So…why isn’t the stock market soaring this week?

Why is the Stock Market so Hesitant to Rise This Week?

According to the numbers, December is the best month of the year, as measured by the S&P 500 or Russell 2000, and December is the #2 month as measured by the Dow or NASDAQ. But that great performance masks a fairly wide series of price swings. According to The Almanac Investor, December starts and ends strong, but there is a dry spell around now, in the second week of the month. Here’s a typical December:

The first three trading days of December are historically strong. (Amen to that. The first three days this December rose 3.75% in the S&P and NASDAQ). Then, according to The Almanac Investor, “trading remains guarded through the first half of the month as tax loss selling wraps up. Once mid-month passes, stocks rise on the majority of days.” Furthermore, small caps start to outperform large-cap stocks near the middle of the month. The “January Effect” starts in mid-December now and the bulk of small stock gains are in the books by mid-January. In late December, the “Santa Claus rally” lifts stocks sharply during the last seven trading days of the year (except for that nasty final day, December 31, which is often marred by last-minute tax selling and/or window dressing). Whew! That’s quite a roller-coaster ride for one month.

Historically, the second week of December has often been a drag, even in good market years. Last year, the Dow rose 200 points December 1-4, then fell 300 points until December 18, then rose 340 points until December 30, only to fall 120 points on December 31, for an anemic net gain of 83 points (+0.8%).

During the big bull market of the late 1990s, we saw similar downdrafts in the second week of December:

  • In the week of December 9-13, 1996, the Dow fell 170 points (2.6%) in two days, in reaction to a speech by Federal Reserve chief Alan Greenspan the previous Friday, when he warned investors against “irrational exuberance” in the market. The market paused briefly then continued rising.
  • After a 325-point gain in the first week of December 1997, nearly all those gains were lost in the second week (December 8-12, 1997), when the Dow fell by 311 points (-3.8%), in a crescendo of ever-larger declines: Down 38 points on Monday, down 61 on Tuesday, 71 on Wednesday, and down 130 points on Thursday, December 11. Friday’s decline was mercifully smaller, only 11 points. Then, the Santa Claus rally lifted the Dow to a 1.1% overall gain for December, 1997.
  • In the week of December 7-11, 1998, the Dow fell from a close of 9070 on December 7 to a close of 8695 the following Monday (-4.1%) before rising 500 points in the second half of the month.

So, we’re entering what you might call the “Dog Days of December” (about December 4-18), but don’t be misled by watching each day too closely. We will likely see a major switch from low-yielding and potentially dangerous sovereign bonds – whether they be state, local, federal, emerging market, or euro-debt – to stocks and bonds in major corporations, with their much better balance sheets. Corporate bonds and well-selected stocks should continue to beat most government-issued debt instruments into 2011.

Article printed from InvestorPlace Media,

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