During the devastating stock market meltdown of the early ’00s, the financial media was quick to point out (albeit after the fact) that much of the pain could have been avoided if individuals had invested a larger percentage of their assets in fixed-income securities. As the market declined, investors vowed to never again allow their portfolios to become disproportionately weighted in equities.
However, judging from recent money flow action, we are concerned that the lessons of the past are being disregarded.
According to the Investment Company Institute, municipal bond mutual funds experienced a net outflow of $2.821 billion in August. This was the second consecutive month in which outflows exceeded $2 billion and was the largest outflow since April 2000. Thus far in 2003, tax-free funds have lost $2.106 billion, compared to a net inflow of $15.192 billion over the same period last year.
At the same time, stock funds had an inflow of $22.91 billion in August on top of $21.45 billion in July.
Although these statistics only involve mutual fund transactions and not the purchase or sale of individual securities, these money movements often reflect investor sentiment.
A cautionary note
As pleased as we are to see investors recoup some of the money lost in equities over the last few years, we think we should sound a cautionary note regarding pronounced shifts in asset allocation.
We would be the first to admit that we have no idea whether the heady days of the late ’90s are back or if the stock market is already overpriced. There are still numerous questions regarding the sustainability of the economic recovery and the quality of corporate earnings. There is also continued uncertainty regarding the inability of the economy to create jobs as well as questions regarding the strength of the Gross Domestic Product once the tax cut stimulus has run its course.
Bond bulls suggest that the economy always does well in the year prior to an election year and that the positive effects of the Bush tax cut will dissipate in 2004, while bond bears are concerned that rising deficits will bring inflation and higher interest rates.
Remember the “D” word
Fortunately, the disciplined, diversified investor need not fret about this cloudy crystal ball. The generous yields on tax-free bonds today make diversification a no brainer.
Long-term, insured municipal bonds can be purchased to yield more than 5.00%. An investor in the 35% tax bracket would need to find a comparable quality taxable bond yielding over 7.70% to match the net 5.00% return of the muni, which is simply not available in other fixed income markets. Thirty-year Treasury bonds yield approximately 5.25%, government agency bonds yield 6.00% and high-grade corporates are under 7.00%.
An even more compelling reason to own tax-free bonds, however, is the steepness of the muni yield curve. As we have illustrated in our “Cost of Waiting” series, parking investment dollars in a money market fund, netting less than .50% – even for a short period of time – can prove to be a very costly proposition.
By the way, we don’t believe the trend toward lower inflation and interest rates is over. Despite one encouraging month, we don’t see any meaningful increase in employment in the foreseeable future, and 2003 will mark the fourth consecutive yearly drop in household income. This is not the stuff that robust economic growth is made of.
Lessons of the past
It isn’t easy to reconcile the outsized gains stocks have recently made amid the present economic uncertainty. That’s why we think this is an excellent time to reflect on the lessons of the past.
Here are a few reminders (what we say when we talk to ourselves):
- Investing is a long game. Diversify and stick to your long-term investment objectives.
- Avoid knee-jerk reactions instigated by day-to-day market action and media cheerleading.
- Keep your interest clock ticking!
