The recent surge in interest rates touched off widespread fears that the bond market’s day of reckoning had arrived. Investors’ anxiety, reinforced by speculation about a Fed tapering and hints of a great rotation to equities, fueled a “sell bonds now and ask questions later” frenzy that spared no sector of the fixed income market. Many investors who sold bonds (or are thinking about doing so) are likely eyeing equities, especially as they see the U.S. stock market reaching record highs.

As such, you may be confronted by clients asking: Should we sell bonds and buy stocks?

Advise against such temptation—for four reasons.

First, remind your clients that the short-term movements of the financial markets should not dictate a long-term investment strategy. Indeed, rash moves are rarely rewarded. As we suggest in Advisor’s alpha, you are a behavioral coach.

Second, because stocks have outperformed bonds over the past year, and even more dramatically since the depths of the 2008–2009 bear market, investors in a balanced 60% stocks/40% bonds portfolio as of June 30, 2012, would now be holding a 66% stocks/34% bonds portfolio.* As such, it may be an opportune time to rebalance, which would require directing new cash flow to bonds or selling stocks to buy bonds, as counterintuitive as that may appear.

Performance of the S&P 500 and Barclays U.S. Aggregate Bond Indexes
1GreatRotation_072013

Source: Vanguard Investment Strategy Group calculations based on Bloomberg data as of July 22, 2013. Past performance is no guarantee of future results. The performance of an index is not representative of any particular investment, as you cannot invest directly in an index.

Third, offer your clients a few numbers** to put the current stock market in perspective:

  • The S&P 500 has risen 175% since its trough during the financial crisis.
  • The S&P 500 is trading at a price/earnings (P/E) multiple*** of 17.4, roughly 10% above its historical median of 15.9.
  • The S&P 500 P/E multiple ranks in the 70th percentile of historical performance.

The forest through the numbers: We are experiencing the fourth-largest bull market in history (as measured by gains without a 20% correction).

Bull markets in U.S. history, ranked by magnitude of gains in the S&P 500
2GreatRotation_072013

Source: Vanguard Investment Strategy Group calculations based on Bloomberg data as of July 22, 2013. Past performance is no guarantee of future results. The performance of an index is not representative of any particular investment, as you cannot invest directly in an index.
* This date does not indicate the end of the current bull market.

While we are not predicting the next bear market or even a sharp pullback, it is worth emphasizing to clients that stock downturns are much more severe in magnitude than bond downturns. The 2% loss observed in the bond market year-to-date could pale in comparison with the potential losses and volatility that could be reasonably expected should the equity market correct.

Finally, clients who are reluctant to stay in bonds because of ominous warnings of a fixed income bubble might be reminded of the important role that high-quality bonds still play: diversification. Even with the probability of loss, high-quality bonds, such as U.S. Treasuries, are one of the few asset classes negatively correlated with equity tail risk, making them among the best diversifiers of equity risk (check out our recent research).

So at a time when the temptation is to move with the great rotation, the prudent course is to refocus on the long-term view, a course that has served investors well over the long term.

What can you do?

Given the sell-off in bonds, now may be a good time to check in with clients. Here are some suggestions to start a conversation:

  • Remind clients that asset allocation—not market-timing or securities selection—has historically determined the overwhelming majority of the risk and return of a typical diversified portfolio engaged in limited market-timing.
  • Speak with your clients about their long-term goals and help them think of their objectives within the framework of their risk tolerances and time horizon.
  • Show your clients the math behind the amount of risk that could be present in their portfolios to reinforce the message of diversification and sticking to a long-term strategy.

Our recent Vanguard’s framework for constructing diversified portfolios will help in your client conversations; so may a recent Q&A with three of my colleagues in Vanguard’s Investment Strategy Group.

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* Using the S&P 500 as a proxy for stocks and Barclays U.S. Aggregate Bond Index as a proxy for bonds, a balanced 60% stocks/40% bonds portfolio on June 30, 2012 have shifted in composition to 66% stocks /34% bonds due to the total return of 27.4% in equities and loss of 0.2% in bonds as of July 22, 2013.

**As of July 22, 2013.

***The P/E multiple of an index is defined by the total price of the index divided by its total earnings.

Notes:

All investing is subject to risk, including possible loss of principal.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index

Diversification does not ensure a profit or protect against a loss.