How Bonds Could Beat the Dow in 2014

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Most investors came into 2014 convinced of one thing: even if the Dow Jones Industrials couldn't pull off a repeat of its 26% gain in 2013, it would at least be a better bet for investors than putting money into the bond market. Yet more than a month into 2014, the Dow is down almost 5% while most bonds have actually gained ground. As many confused investors have started dumping their stocks and moving back into bonds, is it really possible that bonds could beat stocks this year -- or will those making the switch now end up with even bigger regrets by the end of 2014?

Source: U.S. Treasury.

What we've seen
The moves in the bond market haven't been all that extreme so far in 2014, but they've nevertheless been surprising, especially in some areas. Long-term Treasuries have done quite well, with the iShares 20+ Year Treasury ETF climbing more than 5% year to date. The bond market has generally posted more modest advances, with the iShares Core Aggregate Bond ETF gaining about 1.5% for the year.

Certain niches have had to overcome even bigger challenges to post gains. The iShares National AMT-Free Muni ETF is up 2.5% despite ongoing concerns about state and local finances. Even junk bonds have risen a bit, with SPDR Barclays High Yield ETF climbing almost 1% despite its traditional correlation with the stock market.

What we'll see for the rest of the year
Both stocks and bonds are reacting to the changing readings on the economy that we've seen in recent months. For stock investors, the main concern is that after five years of huge gains for the market, everyone seems to be looking for the slightest excuse to reduce their exposure to stocks. Cutting stock allocations somewhat might be warranted for those who haven't rebalanced for a long time, but many investors simply want to try to time the market and avoid losses from what could become an extended correction.

For bond investors, though, the dynamics are much different. No one knows how the Federal Reserve might react to signs of ongoing economic weakness, especially as it gradually reduces the amount of its monthly bond purchases. So far, most economists have written off sluggishness in growth as a one-time seasonal phenomenon, but if recent readings indicating worsening economic conditions persist, the Fed could be driven to respond. Already, even the possibility of that scenario playing out has cut a third of a percentage point from long-term bond rates, and if it becomes reality, then the long-awaited rise in rates could come to an abrupt halt quickly.

What could happen
In 2011, the iShares 20+ Year Treasury ETF gained 34%, as 10-year Treasury rates fell from 3.3% to 1.9%. That year was marked by doubt about the future direction of the economy, and it included huge efforts from the Fed and others to stimulate economic growth. If 2014 falls into the same pattern from a macroeconomic standpoint, then as unlikely as it might have seemed just months ago, the bond market could indeed be a star performer of the year. Yet if the economy doesn't go into the freefall that everyone's afraid of right now, then it could push stocks toward the same sort of outperformance investors saw in 2013.

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