Don't look now fans, but there is a new bubble brewing in the investment world. However, the bubble may not be billowing where you might expect. With the stock market having run 62% in six months and valuations quickly becoming a little rich, many investors are worried about a big decline in stocks. And while a meaningful correction in equities is becoming more likely with each passing month, the stock market may not be the big problem going forward.
What if I told you about an investment that has seen money been pouring in at a record rate lately? What if I told you that in this particular investment arena, new money is coming in so quickly that mutual fund managers literally can't get the money invested fast enough? And what if I told you that there is almost a 100% chance that the driver of this particular market would turn negative in the not-too distant future? Would you be worried?
Well, you should be. And we're not talking about U.S. small caps, technology, gold, oil, or even the emerging markets. No, we're talking about the bond market. And more specifically, the public's misperception of how bond funds work.
The "Flight to Safety" Trade
The last time the stock market got tagged for big losses during the 2000–02 "Tech Bubble Bear, the public quickly became fed up with the red ink in their growth stock funds and switched to what their financial planners were telling them was the relative safety of bond funds. Money poured into bond funds of all shapes and sizes because financial advisors, brokers, and the like had plenty of empirical proof (i.e. academic studies) that showed bonds were safer than stocks.
Up to that point and according to data from the Investment Company Institute, the highest net inflows (inflows minus outflows) in bond funds during a single month had been something on the order of $12 billion in early 1987. But surprisingly, the big inflow into bond funds came BEFORE the Crash of '87. Instead of the buildup in bonds being a "flight to safety," investors at that time were actually chasing returns as this was the heyday of the junk bond market. And we all know how that turned out.
Prior to the 1985-87 period, the records show that the high water mark for net inflows into bond funds on a monthly basis had been less than $1 billion. And after the demise of the junk bond market, bond funds actually saw consistent net outflows until the first Gulf War sent stock investors scurrying for cover.
It wasn't until the mid 1990's that the public learned to love bonds when things got scary in the equities market. Thus, we saw a big net build in bond funds from 1991 through 1993 and then again after the LTCM/emerging markets crisis in 1998. But the bottom line is that neither of these "flight to safety" periods caused bond fund inflows to exceed the $12 billion level seen in 1987.
Now fast-forward to the Tech Bubble Bear in stocks. Investors ran for cover in 2001, causing bond fund assets to soar as net inflows exceeded $17 billion by the middle of the year.
