Time for bonds
Some years ago, I wrote a book called Low-Risk Investing in the ‘90s. I was thumbing through it the other day when I came across a simple chart that I had forgotten about. It was titled “When to Invest in What” and it showed the optimum time to buy securities in each of the three primary asset categories, stocks, bonds, and cash, according to where we are in the business cycle. The chart was drawn in the form of a bell-shaped curve that began at the low point of a recession, trended upward through the recovery stage to the peak, and then slid back into recession again.
Of course, only in hindsight do we know exactly where we were in a cycle at any given point in time. But I think it’s reasonable to assume that we are at or near the peak of the current cycle, if in fact we haven’t already passed it and started down the other side.
There are plenty of indicators to support that view. Statistics Canada tells us that second-quarter GDP growth had decelerated to an annualized rate of 2 per cent, well below the 3.6 per cent first-quarter figure. The U.S. housing market appears to be falling off a cliff. Some economists are becoming incresingly concerned that the American economy may be heading for a hard landing which could result in a recession in 2007.
However all this plays out in the months to come, it’s clear we are not in the early stages of an economic recovery which, as my chart showed and common sense confirms, is the best time to buy stocks. Maybe there’s a little life left in this market, but looking out six months it is hard to be wildly bullish.
So what does the chart say to do now? Weight your portfolios more heavily in favour of cash and, especially, bonds. Although there is one significant obstacle to be overcome, I think there is a lot of profit potential in the bond market over the next 12 months.
Most investors tend to lose sight of the fact that bonds don’t just throw off interest income. They can also produce excellent capital gains in the right circumstances. People who were brave enough to fill their portfolios with bonds back in the early 1980s when inflation was rampant and North American interest rates were at record highs ended up making huge gains. We’re not looking at profits of that magnitude today, but the situation offers some parallels.
Of course, interest rates are nowhere near as high as they were back then. In fact, they are actually still low by historical standards. But we know from recent experience that they can go a lot lower in times of economic distress. When that happens, it’s like manna from heaven to bond investors, especially those who hold longer-term government or high-quality corporate issues.
Remember that the best time to buy any type of security is when it’s out of favour. Bonds qualify. They have been going through a rough period, with the average Canadian bond fund generating a return of only 0.99 per cent in the 12 months to August 31. But the tide appears to be turning. All the Scotia Capital bond indexes moved up in September. The Universe Bond Index gained 1.05 per cent but what was more significant was the fact that longer term bonds did even better. The Long-Term Bond Index was up 1.79 per cent for the month and that came on the heels of a 2.85 per cent jump in August. That’s a major move in bond terms.
Bonds are not yet a slam-dunk, however, because of the one obstacle I referred to earlier. That’s inflation and it could derail the bond market rally if the CPI doesn’t moderate fairly quickly. For the past 25 years, central bankers have made controlling inflation their number one priority and the spectre of runaway prices haunts their dreams at night. However, the recent drop in the price of oil suggests that the inflation bogeyman may be fading away.
This is not to suggest that you should avoid the stock market entirely and switch everything into bonds. The investing world rarely unfolds exactly as predicted. But if you’re underweight in bonds, as most people are, and are considering taking some stock profits, this is a good time to do it. My feeling is that a year from now you’ll be glad you did.
This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm