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Learn From the Arctic Fox Before This Bubble Pops

Tuesday, November 13, 2012 16:02
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The Arctic fox can teach us something about investing.

As the seasons change, the coat of the Arctic fox changes color. During the spring and summer, it has a dark coat to match the brown dirt in its environment.

But in the fall and winter, its coat turns white to match the surrounding snow. By changing its color to match its habitat, the Arctic fox is better able to hide from predators.

It adapts to survive.

And that’s the lesson we should learn: If you want your portfolio to survive and prosper, you need to make adjustments according to a changing investment environment. A static portfolio in today’s market will simply not work.

When the “Season” Changes, it’s Time to Adapt

Markets have a cyclical nature. That’s a fact nobody can deny. Assets come into and fall out of favor depending on the market environment.

Sometimes it makes sense to have a lot of exposure to commodities. Other times, it makes sense to invest more heavily in bonds. When the risk of inflation is rising, for example, hard assets, such as commodities, tend to perform much better than fixed-income assets.

This cyclicality also works for sectors. At any point in time, some sectors are cycling into favor while other sectors are cycling out of favor.

When the risk of a recession increases, for example, investors tend to favor safety. Defensive sectors, such as consumer staples and utilities, tend to perform better than the overall market.

A static portfolio that has the same allocation regardless of the market environment ignores all that cyclicality. As a result, a static portfolio fails to capitalize on big trends and ends up taking on unnecessary risks.

Bonds provide a good example.

Investing in bonds has been a great idea for the past three decades. But, like any other asset, bonds will eventually fall out of favor. And this may happen sooner rather than later.

This Will Catch Many Investors by Surprise

Pacific Investment Management Co., better known as PIMCO, is the world’s largest bond fund. About two years ago, the firm launched its first equity portfolios to diversify away from its core bond business.

Why is the largest bond fund in the world diversifying away from bonds?

Well, it doesn’t take a rocket scientist to figure out interest rates can’t go much lower. That means bond prices can’t go much higher (when rates fall, the price of fixed-income assets rise).

As Bill Gross, the founder of PIMCO, recently said, “Unless a hundred years of financial history are meaningless, bonds must go down – and yields, and interest rates, up.”

But it seems everyone is ignoring Gross, arguably the best bond investor ever. Since December 2007, investors have poured more than $1.1 trillion into bond funds. That’s more than 33-times the amount they’ve invested in stock funds.

So when bonds start turning, it will catch many investors by surprise, despite the warnings from Gross.

This 30-Year Bull Market is Coming to an End

I can’t tell you exactly when the 30-year bond bull market will be over. But this love for bonds is a strong indication we’re close. This is exactly what happened with tech stocks in the early 2000s and housing in 2006.

In the late 1990s, before the stock market crash, everyone viewed stocks as the best investment you could make. After years of a bull market, everyone thought stocks could only go up.

In 2006, before the housing crash, everyone viewed real estate as the best investment you could make. After years of booming prices, everyone thought housing prices could only go up.

And now, the crowd loves bonds. They’ve been rallying for over 30 years now. This bull market has created a perception you can’t go wrong investing in bonds.

The chart below shows the yield on 10-year Treasury bonds. Yields have dropped from 15% to below 2%. When yields drop, the price of bonds rise. So the downtrend in yields represents the bull market in bond prices.

Treasury Yields Have Been Falling For 32 Years

See larger image

It’s very unlikely yields will go below zero. So there’s very limited downside. In other words, bond prices have very limited upside potential and tremendous downside risk.

Today, investors still see bonds as one of the safest assets. But they may just be one of the riskiest ones.

Investors who fail to adjust their portfolios to the coming bear market in bonds will take a big hit. So remember the lesson from the Arctic fox: adapt to survive.

Regards,


Evaldo Albuquerque

P.S. Adapting to survive is exactly what some little-known U.S. companies are doing to make it through these turbulent economic times. In his Global Growth Strategist service, Jeff Opdyke is looking at small U.S. companies that are finding big profits by tapping into rapidly-growing markets around the world. Right now, he’s looking at one company in particular he thinks could be the next “millionaire maker.” To learn more about Jeff’s research, click here.



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