Buy stocks, sell bonds

By Felix Salmon
August 8, 2011

S&P downgraded the U.S. on Friday evening; the markets then had all weekend to work out what that meant, with the verdict arriving when markets opened Monday morning: stocks fell about 1.5% or so. That was about right, it seemed to me: the downgrade was important enough to take seriously, but not important enough to panic about.

And then stocks just kept on falling. As I write this, the S&P 500 is down 5.6% on Monday, wiping out a year’s worth of gains. That’s a big move, and no one knows where it might end.

From a market-dynamics perspective, we’re now in the world of momentum trades and falling knives. This isn’t a repricing of risk based on new information: it’s a trader’s market, which will move in the direction of inflicting the maximum amount of pain on the maximum number of people.

I’m not saying that this is an overreaction — the U.S. downgrade is a legitimately momentous event, and will have a large number of unknowable repercussions. A world which highly values predictability and certainty has become significantly less predictable and certain than it was last week. Does that mean that U.S. stocks are worth 20% less than they were at the market highs around 1,370 on the S&P? No — and that’s one reason I’m looking at this move more like a 20%-off-sale than a sign of incipient economic Armageddon.

What’s fascinating is the way in which all of the carnage is happening in the stock market, rather than the bond market: Treasuries themselves — the very instruments which were just downgraded — are up on the day, with the 10-year bond yielding a shockingly low 2.36%.

Faced with all this, what’s an individual investor to do? The first best answer in all such situations is always the same: nothing. Times of high volatility and market panic are a great time to go off to the beach and try to forget about your retirement portfolio — you want a clear head and a long-term horizon, rather than an obsession about what markets did today.

That said, however, one strategy might make sense, given what’s happened to stock and bond markets of late: a simple portfolio rebalancing. What’s your ratio of stocks to bonds? If you had it where you wanted it a few months ago, then right now, with stocks down and bonds up since then, you’re likely overweight bonds. So sell some bonds (they’re very expensive, thanks to all this panic), and buy stocks with the proceeds, until you’re back to your optimal asset allocation.

And while you’re at it, you might want to revisit that asset allocation, and ask yourself whether having all that money in bonds is particularly smart. If you’re invested for the long term — a 10-year time horizon, say — then a 2.4% yield over those 10 years is utterly pathetic, and can easily get eaten away by inflation alone. Meanwhile, with expected earnings of $99.83 per share this year, the earnings yield on the S&P 500 is a whopping 8.8%.

This is one of those times that stocks genuinely look safer than bonds. They might well go down, of course, in the short term. But on a relative-value basis, they’re looking decidedly cheap.

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