With Bonds Crashing, The Broader Stock Market Could Start To Struggle

market bondsMike Larson: The bond market hits just keep on coming.

The latest from The Wall Street Journal: A whopping $13.5 billion flowed out of municipal bond mutual funds in June. That represented more than 2 percent of all the assets the industry manages. It was also the second worst outflow in 21 years of record keeping.

And no wonder investors are fleeing. A muni-bond index maintained by Barclays suffered its worst monthly loss since September 2008, during the depths of the credit crisis.

Still, I wouldn’t be surprised to see outflows slow for a bit, because the bond market is temporarily stabilizing. But my big-picture perspective is that long-term bonds are a sucker’s bet.

With bonds crashing, the broader stock market could start to struggle.
With bonds crashing, the broader stock market could start to struggle.

At around 2.6 percent, up from 1.6 percent two months ago, the 10-year Treasury still doesn’t offer enough yield to compensate for the risk. Federal Reserve Chairman Ben Bernanke, after all, said last month that the central bank is likely to reduce its bond-buying program as early as this year. So the biggest buyer in Treasuries, scooping up tens of billions in government bonds a month, is about to disappear from the market.

If yields continue to rise, as I expect, even more of the “hot money” that flowed into bonds over the past four years will flow back out. And there’s a ton of that money trapped in bonds because we’ve just come off four years of record inflows into bond mutual funds and ETFs.

But with all that money flowing out of bonds, what will it flow in to? I see two possible scenarios.

The first and, in my view, more likely scenario is that the bond crash leads to a sharp break in other assets. That’s because bonds are no capital-markets sideshow. They are the sun around which all other markets orbit.

Consider a few of the other markets that have already been hammered by the sharp rate rise we’ve seen. The Indian rupee just fell to its lowest level ever against the dollar, while the Brazilian real suffered its worst one-month rout in almost three years.

Copper futures sank to $2.99 a pound, the lowest since July 2010, while platinum fell to a level not seen since November 2009. Sugar, corn, wheat, and soybeans have all declined sharply.

Meanwhile, many interest-sensitive stocks and ETFs remain on the ropes. D.R. Horton (NYSE:DHI) and Lennar (NYSE:LEN) are trading near the lowest levels since last September. Wood products and timberlands firm Weyerhaeuser (NYSE:WY) barely bounced this week — even as the broader market popped. And the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT) is languishing at levels not seen since late 2011.

Is it so hard to believe that, with bonds crashing, emerging-market currencies plunging, many commodities tanking, and several rate-sensitive sectors of the stock market falling off a cliff, that the broader stock market will struggle? I sure don’t think so.

In this scenario, I wouldn’t be surprised to see more scared bond money flow into cash and cash-like assets. That’s why I’ve been taking several rounds of profits off the table in my portfolio, and why I’m boosting my hedges.

The other possible scenario? Money that flows out of bonds goes aggressively into stocks, especially those that might benefit from rising rates, or at least not be hurt by them.

I’ve seen notable strength in names like CME Group (CME), the futures and options exchange operator. That’s because rising rates make it so more clients need to use CME’s products to hedge their interest-rate risk.

You’re also seeing some money come into transports, select technology stocks, and others that benefit from a stronger economy. The thinking there seems to be: “This is a normal rate rise that you get when growth picks up, not the unwinding of a massive bubble in bonds, so it’s safe to buy.”

A final verdict may not be rendered by the market right away. But I believe this isn’t a time for market heroics and chasing stocks willy-nilly — because if there’s anything I’ve learned over the years, it’s that major bond market sell-offs often lead to pain in equities.

Mike LarsonThis article is brought to you courtesy of Mike Larson

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