Bullish Prediction For Stocks

Last Updated Aug 24, 2010 11:03 PM EDT

I was delighted to read a recent article entitled Investors Flee Stocks in Droves In Favor of Bonds. According to the Investment Company Institute, investors have pulled over $33 billion from U.S. stock mutual funds this year, through July. Meanwhile, investors poured $185 billion into bond mutual funds.

Why this is good news for the stock market
The reason I'm delighted is because this migration into bonds bodes well for the stock market. I know that investors are generally horrendous at timing the market, and more often than not negative investor sentiment is correlated to a bull stock market. Money poured into the stock market in early 2000, before the tech bubble popped, and again in 2007, just before the real estate bubble popped. Conversely, money poured out in 2002 and early 2009, as two of the greatest bull markets began.

Now don't take this to the bank. I noted investors are usually wrong, but not always. It can take many years for bubbles to pop and for pessimism to fade, so this doesn't work every year. Nonetheless, I take this as a very good sign.

Why this is bad news for bonds
Investors not only time the stock market poorly, they do the same for bonds. So funds pouring into bonds is a sign of a bond bubble. I've seen many investors going out long on the yield curve or buying lower quality bonds to get higher yields. Much of this is because advisors want you in riskier bonds since it's hard for them to justify charging you a one percent annual fee on a bond fund earning only the same amount.

In fact, I'm seeing new clients come in with bonds and bond funds having durations well over ten years. If rates go up even two percent, those bonds will drop by about 20 percent. And as living proof that investors have short memories, I'm seeing the same type of junk bond funds that got killed only two years ago.

My advice
Of course I don't know that the next year will be a bull for stocks and a bear for bonds. But I do know that picking a portfolio allocation, and rebalancing, puts you on the less traveled path of the contrarian. This accords you an advantage over most investors, who are treading the much traveled path of performance chasing. And let me tell you that path is as congested as the traffic jam in Bejing, and gets you to your financial goals about as quickly.

Never forget that bonds should be your portfolio's shock absorber. Don't get greedy by going out long on the yield curve or by buying junk. The one exception on the yield curve are long-term CDs with easy early withdrawal penalties such as this CD by Discover Bank. This CD can provide you long-term yields without the risk.

And, finally, avoid the pitfalls of listening to your emotions and following the herd. I know I beat that drum a lot but, if you don't believe me, consider the words from Warren Buffett.
"Be fearful when others are greedy and greedy when other are fearful."
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  • Allan Roth On Twitter»

    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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