Bonds Away! Stocks May Not Be the Play

By Daniel Kadlec

Investors trip up in dozens of silly ways. They act on stock tips from their nitwit in-laws, send money to brokers they've never met, check their mutual-fund balances too often and lose patience too soon. But my guess is that this year's most popular gaffe will be the way investors categorize in their mind the past few years of robust U.S. stock gains. Some lost souls will view the spoils as perfectly normal and expect more of the same. God bless them. But even those with a sense of history may regard the period as merely unusual when, in fact, the stretch is unprecedented.

Does that mean it can't go on? That stocks must finally tumble in 1998? No. Perhaps the market's bounds will keep stretching like the elastic belt on your holiday trousers. But it does suggest that the risk of a retraction is more acute. A stiff sell-off last week--the worst New Year's start in seven years--underscores that point. And with Federal Reserve Chairman Alan Greenspan now spouting off about possible deflation in the economy, it may pay to favor bonds for a while. I'd certainly be slow to invest any new wads of cash--say, a year-end bonus--all in the stock market. More on that later. First, let's take stock of the times.

The Standard & Poor's 500, including dividends, rose 33.4% last year, 23.1% the year before and 37.4% the year before that, according to research firm Ibbotson Associates. This is the first time that the index has risen more than 20% in three successive years, and is the best three-year run ever. The index rose in each of the past seven years--not a first, but rare. And in that seven years it dipped as much as 10% only once, a record. The amazing run has prompted millions to stake their retirement on the bull market and by now has convinced many that a new era of prosperity is upon us.

One believer is economist Paul Boltz at T. Rowe Price, who notes that in the past 15 years the U.S. has been in recession only eight months, a growth line like no other. "What we are living through is astonishing," he says. So go ahead and pinch yourself. It isn't a dream. If you've been in the market for three years, yes, Virginia, you've doubled your money. So, even though we don't know how long this will last, the best course may be simply to stay in stocks, particularly if you have 15 or more years until retirement. Consistently trying to time the market's ups and downs is one of the silly ways that investors trip up. Few can do it.

On the other hand, there's nothing wrong with a little skepticism. Let's face it--no party lasts forever. How much would it hurt if the market suddenly fell 30% and stayed down for months or even years? Don't think it can't happen. Japan, only 10 years ago thought to be economically invincible, is in the ninth year of a horrendous bear market in stocks. Few expect anything like that here, but the wave of problems in greater Asia could be enough to tip the U.S. over the edge. Some Asian currencies are now half what they were relative to the dollar just a few months ago. That means those nations enjoy dramatically lower production costs and can sell goods in the U.S. at far lower prices, forcing American companies to drop prices too. That's bad for profits and bad for stocks. In the worst case, it leads to sustained price declines throughout the economy, which is deflation. It hasn't happened in the U.S. since the 1930s, and though many things--including oil, computers and cars--are getting cheaper, it probably won't repeat anytime soon. Still, deflation has become the worry du jour on Wall Street. By mentioning the D word in a recent speech, Greenspan gave the notion credibility.

That's why bonds may outperform stocks this year for the first time since 1993. As things get cheaper, the value of bonds that generate fixed, secure interest payments goes up. But even without deflation, bond prices could rise because that more infamous bogeyman inflation now seems skewered. Indeed, bond mutual funds have begun to get their first regular inflows in three years. Last week a rush to buy Treasury securities pushed prices up and drove the benchmark 30-year T-bond yield down to 5.71%--the lowest since the Treasury began issuing the 30-year bond in 1977. Only four months ago, the T-bond yield was 6.69%. Bond investors have been handed a 13.9% gain since then, while stocks have gone down.

Among the pros who believe bonds will continue to outshine stocks are Barton Biggs, top investment strategist at Morgan Stanley Dean Witter, and Charles Clough, top strategist at Merrill Lynch. Biggs is especially enthusiastic, saying the T-bond yield could sink below 5% and generate a total return approaching 20% for the year. Meanwhile, he expects U.S. corporate profits, because of problems in Asia, to drop as much as 10% and trigger the worst stock slide since 1987.

Late in the Roaring Twenties, during a great bull market in stocks, financier Andrew Mellon famously warned that "gentlemen prefer bonds." The hordes of stock-crazed investors must have chuckled at that one. But Mellon wasn't a funny guy, and come 1929, the joke was on them.

Daniel Kadlec can be reached at kadlec@time.com