Poll reveals public is uneasy about stocks in 2014

A new survey by the Associated Press finds that most Americans think the stock market will not go up in 2014.

About 40% think that stocks will be just about where they are now at the end of 2014, and almost another 40% predict it will go down. Very few think it will crash, but the percentage of bulls is a dismal 14%. CNBC.com reported it here.

We certainly don’t disagree. Back in late October we published a newsletter saying basically the same thing (“Don’t expect a bull market in 2014”). Bullish sentiment was running high at the time, and the fact that popular thinking has changed so quickly to align with ours is somewhat unsettling. Crowds tend to be wrong.

But the poll had other questions that probed deeper into people’s thoughts. While almost 80% say they didn’t think market will go up, about 77% plan to invest as much, or more heavily, in the coming year. Only 22% plan to pull back.

It is easy to dismiss this blatant contradiction as another proof of how irrational people truly are. But these results may also show that people may be wiser than these answers reveal.

Most believe the market will not go up yet again in 2014, suggesting that they intuitively understand that stocks are in uncharted territory. As we showed in our newsletter, stocks had never before gone up 10 out of 11 consecutive years, as they did in the 2003-2013 period (2008, of course, was the exception). Expecting that 2014 would also be a positive year would be the same as expecting an outlier event even less likely than 2013’s unprecedented gain.

But while unlikely, a positive 2014 is not impossible. The US economy is undoubtedly picking up, and there are strong signs that Europe is finally leaving behind the never-ending crisis environment that plagued it for years. These are two powerful conditions that can propel the market higher still, even if central banks start to pull back on monetary stimulus.

So crowds are mad, but that doesn’t mean they are stupid. The contradictory results of the AP survey may actually suggest that they actually understand their limitations: their gut tells them the market may fall, but their heads tells them that they are often wrong. What to do, then?

The inevitable answer seems to be: bite the bullet and leave your chips on the table. Which is also what the majority of Wall Street strategists seem to be saying.

To us, the results of this poll mean that uncertainty is running high. The safest bet, therefore, is that both the general public and the professionals will change their minds often in the coming months. The conclusion is that volatility, long subdued, may raise its head again in 2014.


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US railroad activity points to stronger economy

The Policy & Economics Department of the Association of American Railroads (www.aar.org) just reported that US Intermodal traffic (mostly shipping containers transported on railroads) registered “easily the highest weekly average for any November in history and up 7.8% (73,004 intermodal units) over November 2012.”

Furthermore, the report indicates that “it’s a safe bet that next month in this space we’ll be reporting that 2013 was a record year for intermodal.”

This is important, the AAR says, because “Freight railroading is a ‘derived demand’ industry: demand for rail service occurs as a result of demand elsewhere in the economy for the products railroads haul. Thus, rail traffic is a useful gauge of broader economic activity, especially of the ‘tangible’ economy.”

This is a powerful indicator that cuts through the haze of economic releases and the cacophony of voices offering different opinions on where the US economy is heading. The implication for investors is that improving economic conditions increase the chances that the Fed will start withdrawing monetary stimulus. Last week, for example, we saw US unemployment fall to 7%, the lowest figure in five years, even with a 0.2% increase in the labor participation rate.

This means that there is a good chance that interest rates will go up. Investors should monitor the interest-rate sensitive exposure of their portfolios, and in particular examine whether they are over-exposed to long-term interest rates through bond mutual funds. See our newsletter “Why bond funds can be toxic for your portfolio.”


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How should I think about bonds in my portfolio?

I answered this question on Nerdwallet.com:

How should I think about bonds in my portfolio? I’ve heard people recommend “your age in bonds”, which would leave me on a 43-57 split. Do people do this in practice? It seems like a lot. Or is it more like advice that people give but don’t follow?


A most excellent question, and one that investors should be asking but aren’t.

Most people, including finance professionals, developed all their skills during a 30-year-plus interest rate rally, when the US Treasury 10-year note rate declined from 18% to 1.8%.

This contributed heavily to the thought that bonds are “conservative” investments. In fact, a “conservative” portfolio has become a synonym for a bond-heavy portfolio. That’s why the “age in bonds” rule of thumbs exists: it’s supposed to make it easy for you to become more conservative as you age. However, this rule conceals serious risks that can lead your portfolio to unexpected and serious losses, especially if you invest in bonds through bond mutual funds.

I am sure you already know that when interest rates fall, bond prices go up. As a result, the thirty-year rate rally pushed up bond prices for – you guessed it – thirty years straight. This is a crucial reason why bond funds have been so successful and have been recommended by so many as a safe, “conservative” choice.

Here is the problem, though. Practically all bond mutual fund portfolios have an average maturity target that they must maintain (technically speaking, it’s a “duration” target, a related measure). This means that bond funds rarely, if ever, keep bonds to maturity.

Suppose that a fund has an average maturity target of 7 years. As time goes by, the fund sells bonds that have, say, only five or six years left, and buy bonds with eight or nine years left in order to keep the average maturity within a range. This works great when interest rates decline: funds buy bonds at higher rates and sell them at lower rates. In terms of price, they buy low and sell high. This locks in capital gains.

But when interest rates climb, the opposite is true: bond funds buy high and sell low. This is an inescapable curse for bond portfolio managers, and a nasty trap for investors who suffer a permanent capital loss under this condition. Therefore, it’s crucial that you avoid bond funds in the initial stages of a higher interest rate cycle. For instance, PIMCO’s Total Return bond fund (PTTAX) lost close to 4% of its value in the first nine months of the year as the US 10-year note rate climbed from 1.8% to 2.6%. Most bond funds of similar characteristics fared equally poorly. For more on this read our newsletter “Why bond funds can be toxic for your portfolio.”

If you want bonds because you want to be conservative, you would be better off by putting together a bond ladder, which is a portfolio of bonds with different maturities. This will provide steady income and no loss of principal. Also, because you will hold every bond to maturity, you will always receive back the principal of each bond at maturity regardless of where interest rates go (barring a default by the issuer – stick with very high grade bonds). This shields you from the principal losses suffered by bond funds when rates go up, which will be inevitable as the Federal Reserve starts removing its monetary stimulus. The trick is that you have to reinvest the proceeds of maturing bonds into new bonds. This is OK – you will be buying cheaper bonds as your existing ones mature. But you probably want to work with a financial advisor or investment manager to structure and manage a bond ladder properly.

It may be a bit too early to start a bond ladder, because interest rates, although going higher, are still very low. I would recommend working with a financial advisor to determine what exposure to stocks is appropriate for you, and make the remaining portion – the “conservative” portion – heavy in cash and ultra-short bonds for the time being. As interest rates become more attractive, start building your bond ladder to establish future income at more attractive levels.

Good luck!


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