June is when spring turns to summer, but this year it’s felt like fall for investors in nearly every market.
Bonds have tumbled in value, from Treasuries to corporate debt to municipals, as the focus on a possible end to the Federal Reserve's asset-buying prompted heavy withdrawals from fixed-income funds. Gold is collapsing and is on its way to posting the metal’s worst quarter on record. Non-shiny commodities have also been weak. Emerging markets have led the declines, as China’s banking system heaves. Stocks are down from their highs of May, though they’ve bounced the past couple of days.
This recent across-the-waterfront swamping of most every investment market raises two key questions: Where is the money that is exiting these assets going? And what happened to the balanced interplay among markets that produced offsetting movements and flattered a diversified portfolio?
The question of where the money is going is far more complicated than it sounds. While it’s common to characterize money entering and exiting markets as “flows,” it’s not at all like a torrent of water heading in a single direction, producing increased pressure that automatically propels prices.
While it’s true that more cash allocated to a certain asset increases the identifiable demand for certain investments, the available supply is almost always far in excess of the amount traded. A $30 billion net inflow into stock mutual funds in a month now qualifies as a big equity grab, yet in a $16 trillion stock market there’s always plenty to go around.
Further, consider that when money “enters” the stock market, it’s used to buy stocks from sellers who already own them, thereby producing the equivalent amount of cash in their accounts. As detailed nicely on www.capital-flow-analysis.com, money is forever moving in both directions in every market, cash being swapped for securities in equal amounts. Price changes are simply a function of the relative motivation, or urgency, of buyers compared to that of sellers.
With that in mind, clearly the past month has been about greater urgency among sellers of bonds, stocks and commodities to reduce exposure, without much motivation to immediately reallocate it elsewhere. Proceeds of security sales can be immediately recycled into the same kind of investment, or another market, or used to pay down debt -- or turned into a boat, a vacation or a diamond ring.
So the evident excess of urgency by sellers across most markets, without any asset obviously capturing an outsize percentage of their newly raised cash, implies a sort of broad, temporary paralysis. The default way-station for cash raised is bank and brokerage accounts. When the outlook is considered uncertain and conviction wanes, it sits there longer.
The U.S. dollar has been rebounding sharply, implying a greater willingness among investors to hold short-term dollar instruments such as Treasury bills, either to play the currency appreciation or just wait.
As the initial flight dynamic has matured, and the spasm of rising Treasury yields has settled down a bit, the markets are hinting, hesitantly, that U.S. equities could end up being a relative beneficiary of this turmoil, as investors try to make their peace with a “new” range of interest rates.
Calls for a great rotation from bonds into stocks have been loud all year. It’s hardly a sure thing that a flood of money will obediently pivot away from fixed-income into equities with great haste. Yet on the margin, plenty of the money being knocked loose from bonds will find its way into stocks.
Of course, stocks more than doubled since March 2009 with money being yanked from stock vehicles almost the entire time. So, conversely, greater inflows in themselves wouldn’t automatically drive prices higher.
Municipal bonds have recovered a bit after a panicky selloff in recent weeks. Plenty of collateral damage has been done, and it is an obvious place for bargain hunters to prowl. The iShares S&P National AMT-Free Muni Bond (MUB) fund fell a steep 4.1% from Memorial Day through Tuesday, lifting its federal-tax-exempt yield to near 3%, before the gaining more than 2% Wednesday as bond markets calmed down.
A compatibility question
For long-term investors, a fresh conundrum is the way familiar correlations among various asset classes have broken down for the moment, fouling many carefully constructed portfolios meant to capture their ebb and flow in relation to one another.
During most of the past six years, the markets have oscillated between periods of “risk-on,” when stocks, commodities and riskier currencies thrived, and “risk-off,” when Treasuries and the U.S. dollar were coveted.
Since early this year, when stocks soared as Treasuries stayed strong with their yields depressed, this interplay changed. And with the latest scare related to Fed-policy rhetoric, both stocks and bonds fell in value.
As a result, a new class of risk-parity mutual funds, which seek to mix various assets to play the familiar to-and-fro, have been hammered. AQR Risk Parity (AQRIX) fell more than 6% in the week through Thursday and 10% in the last month -- representative of this whole group of intricately engineered funds.
Billed as an improvement on typical 60%-stock/40%-bond asset allocation funds such as Vanguard Wellington (VWELX), these portfolios have squandered whatever advantage they had built up over the plain-vanilla approach. While not an outright indictment of the risk-parity approach, their slide suggests some kind of climate change occurring in markets.
In the ‘80s and ‘90s, of course, bond and stock values trended higher in tandem. The question now is whether, as Jim Paulsen of Wells Capital Management has argued, rising bond yields from such low absolute levels are perfectly compatible with a strong stock market, as both represent confidence in the economic outlook growing among investors.
If this happens, the adjustment won’t necessarily be instant or smooth. Too much of the stock market’s leadership this year came from dividend-centric stocks whose main appeal came from the lousy perceived income alternatives out there, given low and stagnant government-bond yields.
That picture has been disturbed, and greater confidence in growth-oriented investments will probably be needed to carry the market higher from here.