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Don't Forget About Bonds

 

 

Rule 15

"Where are the bonds?" That's how I used to begin every phone conversation when I was on the road, away from my desk, back when I ran my hedge fund.

Yet people forget the bond market all the time. They forgot it in 2000, even though it told them the economy was softening. They forgot it in 2001, when it was clear that the cash rates were too competitive to stocks and would cause a massive selloff. That's why I say:

 

Don't forget bonds.

 

I was trained to focus on bonds because bonds are the competition to stocks, the competition I most fear. When short-term rates go sky-high, you have to expect companies that had been bought for good yields, stocks like Bank of America (BAC - news) or BP (BP - news), will sell off.

When long-term rates fall to 4%, you have to believe that the economy may be too soft to own deep cyclicals or that stocks that have high yields, like utilities — I like to watch Duke Energy (DUK - news) — will be on the move.

You need to watch more than the stocks. If this were basketball, I would be saying that if you just watch the man with the ball, let's call him Citigroup (C - news), and you don't watch what the others are doing on defense — the bonds — there's no way you are getting to the basket. The men without the ball — the bond market — can determine the action.

Many people who got in this game in the last decade still don't even know what bonds are. They are troubled when you say bonds went up today. They think that means interest rates are going up rather than what it really means, which is that interest rates are going down. If you don't understand how bonds work, I think you will not be able to make nearly as much money as if you do.

By the way, a lot of younger managers think they only need to think about bonds if they own Washington Mutual (WM - news), American International Group (AIG - news) or Fannie Mae (FNM - news).

They don't think bonds matter with a portfolio of Research In Motion (RIMM - news), eBay (EBAY - news) or Qualcomm (QCOM - news).

Wrong! When interest rates move significantly higher, no one's going to pay a lot for the future earnings growth stocks provide.

So keep your eye on the ball, and on the men without it.