We recently received an email from a reporter asking whether we were concerned that there was too much good news. We quickly pointed out that bear markets do not typically occur when good news makes investors nervous. Rather, bear markets typically occur when investors ignore an increasing volume of bad news.

Disregarding or rationalizing deteriorating fundamentals tends to result in higher than expected volatility. Investors generally ignored the deterioration in housing fundamentals prior to 2008, ignored the deterioration of technology fundamentals prior to 2000, but are eagle-eyed regarding every aspect of today’s equity market. It’s

hard to argue that investors are potentially overlooking equity market risk because the data universally show that a broad array of investor classes remains skittish toward equities.

Ignoring actual risks

We’ve repeatedly commented that investors are largely ignoring the growing risks in the fixed-income markets. In fact, investors have continued to allocate to fixed income despite that bond market fundamentals have been deteriorating and bonds have been underperforming for more than two years (see Chart 1). When comparing asset class returns since mid-June 2016 (when inflation expectations troughed), only bonds have provided negative total return. Bond investors haven’t seen significant negative returns

(yet?), but the opportunity cost of investing in bonds instead of other asset classes has been dramatic (see Chart 2).

Inflation risks continue to increase, but fixed-income investors enthusiasm continues unabated. Enthusiasm for an asset class in the face of deteriorating fundamentals seems a classic setup for a significant bear market in bonds. For more on the large and growing risks to fixed-income, see our report “Overheating Ahead” (http://www.rbadvisors.com/images/pdfs/Overheating_Ahead.pdf)

CHART 1:
Cumulative Bond ETF and Fund Flows
(Jun. 30, 2016 – Aug. 31, 2018)

CHART 2:
Asset Class Performance since Inflation Trough
(Jun. 15, 2016 – Sep. 12, 2018)


Source: Bloomberg Finance L.P.
For Index descriptors, see "Index Descriptions" at end of document