The most important question on every single investor’s mind is: what should I do with my money? Should I mainly invest in stocks or bonds for the optimal risk-return payoff?
In this article, I am going to analyze major investment themes over the past few months, which might give us a hint on asset allocation going forward.
First, let’s think about the correlation between stocks and bonds prior to any trend analysis. Known as two distinct asset classes, they are mostly negatively correlated if we consider their trading volumes as the criteria. Nevertheless, they are more like a complement rather that a substitute to each other in the sense that diversification is the key to any investment portfolio.
In the past year of 2013, equity investments dominated the headline. Shown by the FRED graph above, the S&P 500 index rallied 30% over the year, the biggest since 1997, amid improving economic fundamentals and market confidence. At the beginning of the year, the settlement of a critical financial challenge called the fiscal cliff, which referred to automatic spending cuts and tax increases, removed the uncertainty about growth momentum. In particular, investors reallocated their assets to the equity market in anticipation of increasing treasury yields. As the Fed was about to taper its bond purchase program, treasuries might not be a safe-haven anymore because their value would decrease significantly if the yields were to rise from around 2% in early 2013 to their historical average of 5%.
In January this year, capital began to flow back into bond funds for the first time after seven straight weeks of outflows. Traditional U.S. stock mutual funds and exchange-traded funds together saw withdrawals of $18.8 billion in the week ended Feb. 5. Meanwhile, taxable bond mutual funds and ETFs soaked up $10.7 billion, their biggest intake on record, Lipper’s data showed. From my perspective, the shift was primarily due to an adjustment to the U.S. economic projection. Indeed, the economy had been on an upward trend but the strength of recovery might be originally set too high. Besides, the turbulence in emerging markets partly pared confidence in equity investments in today’s interconnected markets.
Most recently, individual investors are jumping back into stock trading, driving business at some discount brokerages to near record levels. At the International Traders Expo in New York, one of the largest conferences for active investors, many of them showed great enthusiasm in equity investment on optimistic economic outlook. Kim Githler, chief executive of MoneyShow Corp., which runs the event, said attendees seemed as enthused as they were before the financial crisis. “People are feeling excited and back in the game,” she said. “The energy is so different.” However, the risk is that they are betting on stock prices at the tail end of a historical rally, given the fact that the S&P 500 declined 3.6% in January, the largest one-month drop since May 2012.
I believe investors are being used to the Fed’s tapering and rationally diversifying their portfolio by adding more bond holdings, instead of solely focusing on equities like what they did in 2013, leading to increased stability in the capital markets.