Note to Bond Bulls: Wednesday's Stock Rally Shows How Quickly Things Can Change

Stock market rally
Stock market rally

Wall Street greeted positive economic data from around the world with a sharp stock market rally to start September. And for most equity investors, the positive development provided a rare ray of sunshine following the most brutal August trading in nearly a decade.

But while stocks welcomed a respite from what some see as a bubble in pessimism, the turn of events should be just as unnerving to a fast-growing crowd of individual investors: those who have recently marshaled their savings into ultrasafe holdings like U.S. government bonds. Such folks saw their new investments take a sharp dive on Wednesday.

The jolt should serve as a reminder of how quickly things can change given the dear prices safe assets are commanding, and it could be a sign of things to come.

Out of Equities, Into Bonds

There has been no shortage of retail investors running for the cover of bonds lately. Debt holdings, including domestic and foreign government bonds as well as corporate bonds, now make up 10% of family financial assets, the highest level since 1970, according to recent data from the Federal Reserve and Credit Agricole. Investors pulled out $7.1 billion from global equity funds but parked $5.2 billion into already-swelling bond funds during the week of Aug. 25 alone.

Benchmarks like 10-year Treasury tumbled on Wednesday as yields spiked to nearly 2.6% following better-than-expected manufacturing surveys in the U.S. and China. The sharp move demonstrates how highly pessimistic is the baseline scenario that an increasing number of investors have begun to gravitate to. Some commentators suggest that bonds could crumble in the face of more positive economic surprises like continued stronger-than-expected manufacturing data in the coming months.

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Investors should note, though, that it would take far less than months of solid economic gains to cause government bond prices to collapse, considering the deeply negative economic sentiment currently being priced in. The paltry yields, after all, are a throwback to the days of the credit crisis when the economic outlook was far more dire than it is now.

And bouts of other good news -- like better-than-anticipated data on the jobs front, due out this Friday -- could send Treasurys reeling as newly emboldened investors depart for assets with higher incomes. Indeed, the meager yields on Treasurys has led some pundits to claim that a bond bubble approaching the level of the dot-com boom a decade ago may be in the works.

Bond bulls tend to counter that the comparison is absurd since investors can usually get their money back -- if they hold U.S. Treasury debt until maturity. For investors who paid top dollar to buy into shares of dot-coms that soon vanished, the contrast will be vivid.

What If Inflation Returns?

However, even if the comparison to dot-coms proves hyperbolic, investors may be making poor decisions by shunning risk in the wake of mounting gloom recently. Simply holding on to long-dated, low-yielding debt like 10- or 30-year bonds is hardly an appealing prospect. And that's especially true if inflationary prospects return along with growth.

Of course, a deflationary scenario where stable assets with some income (no matter how meager) perform well has quickly become gospel following a slowdown in the U.S. economic recovery over the last few months. But investors should think back to the spring, when major publications like Newsweek were cheering the sharp U.S. rebound and the bond market was bracing for big inflationary pressures to recall how quickly things can change.

Wednesday's rally should serve as yet another gentle reminder.