Dreman: Bond Bubble Will Hurt Many

Contrarian strategist David Dreman says a “major bubble that will hurt a lot of people” has formed in the long Treasury bond market.

“Ten-year Treasuries are yielding about 2%, while 30-year Treasuries are at 3%,” Dreman tells Morningstar.com. “Adjusting for inflation and taxes, this has almost never happened before. In the rush to Treasuries after the market collapse and financial crisis of 2008, people’s only thought was to preserve their capital. What they overlook today is that the economy is slowly coming back and the S&P 500 has more than doubled from its low. The Federal Reserve and budget deficits together have almost doubled our national debt since 2008. As unemployment gradually goes down, we are likely to see higher inflation because of the vast amounts of money printed in this country and abroad.” And, he says, a 1% increase in the yield of a 30-year bond “takes principal down more than 15%. If inflation does move higher, Treasuries, one of the best performers of the past decade, are likely to be one if the worst in the next.”

Stocks, on the other hand, are “likely to flourish in this environment,” Dreman adds. He says that improvement in the housing market as excess inventory is worked off, “whether it is a year or two longer”, should be a big boost to financials. And he says European stocks are more attractive than European bonds right now.

Dreman also discusses the psychological aspects of investing. “Unfortunately, gut instinct is the graveyard of all too many portfolios,” Dreman says. “Contrarian strategies, by contrast, are based on very strong statistical probabilities, that investors constantly repeat the psychological mistakes they make over time.” He says that value investors can avoid value traps by following a few important rules, including not buying companies that are reporting losses and having a large number of stocks in an equally weighted portfolio. He recommends holding at least 100 stocks. Dreman also warns against listening to analysts. “Although most analysts believe that if earnings come in even 3% under estimates, a stock can fall sharply, the average consensus miss since the early 1970s has been closer to 50%,” he says.