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Are bonds bubbling?

Economists and investing analysts are engaged in a serious debate about whether the U.S. economy is headed toward inflation or deflation. The deflation arguments have picked up speed this summer, fueled by an increase in reports showing that the economy appears to be slowing again.

While the experts remain (sharply) divided about whether we will tip into outright deflation or not, the mere threat of it has had profound implications on the investment scene.

High-quality bonds are one of the few investments that would be expected to perform quite well in a deflationary environment, and investors have been pouring money into bonds like crazy over the past few years (though not necessarily because they believe the deflation story — there are other reasons investors have flocked to bonds as well, such as fear/loathing of stocks, asset re-allocation by aging boomers, etc.).

The incredible surge of money into bonds and bond funds since 2008, coupled with the stark overall performance difference between stocks and bonds over the past decade, has led to intriguing questions: Are bonds in a bubble? Are stocks attractively priced relative to bonds?

Unfortunately, there aren't clear-cut answers, largely because the answers hinge on the way the deflation/inflation economic path unfolds. And contrary to what many experts would have you believe, nobody knows what will happen next.

This chart (click here to enlarge) stunned me when I stumbled across it recently at The Big Picture blog. For some time now, SMI has been warning about the increasing risk of bond funds due to bond valuations getting stretched (see, for example, my October 2009 article, Re-Evaluating the "Safe" Part of Your Portfolio), but I had no idea that Treasury returns over the past decade resembled those of tech stocks during their heyday.

Big Picture author Barry Ritholtz adds the following commentary:

Over the past few months, I have been saying US Treasuries remind me of the dot com stocks circa 1997-98 in three ways:

1) You knew momentum was taking them (much) higher;
2) You knew it was going to end badly;
3) If you were honest, you admitted you had precisely zero idea when the day of reckoning would be.

Plenty of others, though, say this isn't a bond bubble. They would argue this is merely the rational response to looming deflation on the horizon.

While acknowledging that it's unknowable at this point how this will turn out (future deflation will mean bonds continue gaining, whereas avoiding deflation and a legitimate turn towards economic recovery will potentially expose them to grave danger), it is interesting to note that this long "reversion to the mean" process of stocks becoming cheaper and bonds becoming more expensive has led to valuation conditions we haven't seen in some time.

For example, consider this chart of the Dow Jones Industrial Average Dividend Yield minus the 10-Year Treasury Yield (courtesy of Bespoke Investment Group). The huge amount of money flooding into Treasuries has pushed their yields below the yield currently being offered by the Dow's stocks. Aside from a brief spike during the financial panic, this condition hasn't been seen in nearly 50 years.

Whatever you think about the underlying merits of it, fund flows out of stocks and into bonds have been breathtaking. USA Today reports that since the beginning of 2008, bond funds have had $601 billion of cash inflows, while stock funds have seen $240 billion in outflows.

But here's something to keep in mind: As headlines like this one from the New York Times become more common — "In Striking Shift, Small Investors Flee Stock Market" — remember that small investors usually aren't "ahead of the game" when it comes to timing their investment moves. More often than not, they do things at exactly the wrong time.

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