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  Why The Bond Market May Be In Trouble

October 7, 2010

 

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This is an abbreviated sample of a comment posted for subscribers

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The latest asset allocation survey from the American Association of Individual Investors (AAII) was just released, and it shows a continuation of an odd development.

 

Investors' allocation to stocks was unchanged at 55%, but they increased their allocation once again to bonds, while sacrificing their cash cushion.

 

Their bond allocation jumped 4% to 25% of their total portfolio, while cash dropped 4% to 20%.

 

The odd thing about it is that historically, there has been a very positive correlation between investors' allocations to bonds and cash.  Basically, it's a "fear trade" - when they're concerned, they pull money out of stocks and put it into bonds and cash.  When they're confident, they pull money out of bonds and cash and put it into stocks.

 

But not lately.  Over the past year and a half, the correlation has completely broken down, and investors are now using the bond market as their safe haven.  When they reduce stock exposure, they put it into bonds, and not cash.

 

 

Yes, the interest rate on cash is nearly nil.  But it was also extremely low during periods prior to 2010, and yet the AAII folks still didn't consider bonds to be the only safe haven.

 

The thing that's a little disturbing is that by using the bond market as a default safe haven, investors neglect to remember that long-term bonds do carry the risk of losing one's capital unless held to maturity, which can be a very long ways off.

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