At the beginning of 1987, the yield on the 30-year Treasury bond was 7.4%.
The S&P 500 started the year at 250, and many of the brightest minds on Wall Street were forecasting a run to 350 by the end of the year. Bonds were expensive and stocks were relatively cheap.
Less than eight months later, bond prices had fallen. The 30-year yield was 9.2%. As investors fled the bond market, they plowed their money into stocks and the S&P 500 rallied to 330 by early August.
Cheap stocks became expensive, and expensive bonds became cheap.
Investors could buy the 30-year Treasury bond with its “risk-free” guarantee if held to maturity and receive a 9.2% return. Or they could buy into the stock market with the potential risk of a significant correction, and capture a 7% gain (according to Wall Street’s brightest minds).[ad#Google Adsense]So, would you take 9.2% risk-free, or 7% with lots of risk?
When the crash hit on October 19, 1987, the media was quick to point the blame at program trading, portfolio insurance, and evil derivative products.
All those factors likely contributed to the severity of the decline, but the root cause wasn’t all that complicated. Investors simply decided the potential return from stocks wasn’t worth the risk and the risk-free rate from bonds was a better deal.
Fast-forward to the present day…
Last September, the yield on the 30-year Treasury bond was just over 3.5%. The S&P 500 was at 1,050, and many of Wall Street’s finest were targeting 1,350 to 1,400 by the end of 2011. Once again, bonds were expensive and stocks were cheap.
Now, nearly six months later, bond prices have fallen, and the 30-year yield is 4.75%. Investors have pulled money out of bonds and flocked to the stock market. The S&P is up almost 30% and is approaching the average year-end price target of about 1,375. We no longer have cheap stocks and expensive bonds. In fact, we have quite the opposite.
Investors can now buy the 30-year Treasury and lock in 4.75% “risk-free.” Or they can buy into the stock market with the potential risk of a significant correction, and capture a 4% gain (according to Wall Street’s brightest minds).
So which is it? Will you take 4.75% risk-free, or 4% with lots of risk?
Your answer could cause a crash.
Of course, the media will blame it on high-frequency trading, algorithmic computer programs, and those evil derivative products. But it’s really not that complicated.
Best regards and good trading,
Jeff Clark[ad#jack p.s.]
Source: The Growth Stock Wire