Stocks seem to have nowhere to go but up, sucking more money back into the market with every new post-crash high.

While the ten-year return is still slightly negative, over the last 12-months the S&P 500 was up just under 39%. The 70% run-up from the lows of early March are fueling optimism. Just not around here. We’re planning on slimming down our stock stakes soon. As dyed in the wool contrarians, we prefer when stocks seem to have nowhere to go but down.

This upward trajectory is likely caused by three key factors: 

1. Distaste for essentially zero yields in safe investments like CDs, money markets, and short-term government bonds.</li>
2. Growing optimism by experts that the economy is improving (in sharp contrast to experts' sour expectations for the economy a year ago ... so much for experts)
3. Too much money ... same old, same old

Let's talk about that last factor first. Although the great credit crisis destroyed quite a bit of global wealth, it didn't spawn a depression, which would have destroyed nearly all of it. There is still far more money in the world ready to invest than good places in which to put it. Lately tens of billions of dollars coming out of money market funds each month, but there is still trillions in money market funds and shorter term bond funds, not to mention CDs and bank savings accounts. 

That doesn't mean stocks are a great deal, but it may mean bargains can only be had during brief periods of true panic. If too much of the safe money shifts to the risk money, we'll be back in a very dangerous overvalued market with 1% dividend yields and 30+ P/E ratios, as we were in the late 1990s (only without a pending housing bubble to lift the economy when stocks sink). 

So what about investor optimism? The economy has certainly turned the corner. Whether it can grow fast enough to overshadow the ongoing overhang of bad real estate loans remains to be seen. Maybe all of the stimulus helped, perhaps the tax cuts were beneficial, or maybe consumers can only get thrifty for short periods of time. Unemployment is still high, but it's possible low unemployment rates are overrated as a boost to stocks anyway. Moderate unemployment keeps salaries under control, which helps company profits and ultimately drives stock values. 

As confidence in the economy builds, fear of default risk falls to the wayside. If default is not a risk, then why not load up the truck on the highest-yielding investments you can find? Apparently, many investors are doing just that. We're moving more in the direction of lower credit risk bonds as the optimism builds.

Which brings us to the first point. Investors grow tired of zero yields pretty quickly. At this point, nobody cares about default risk, but everyone cares about interest rate risk – the other side of bond investing. 

Default risk is fast and brutal. Companies go broke and settle claims for pennies on the dollar. Homes decline in value, and homeowners walk away, leaving the holders of the second lien or HELOC-type loan high and dry. 

Interest rate risk is slow and subtle – a phantom menace. One day you buy a ten-year bond that yields 3%. Then somewhere along the line, ten-year bonds begin yielding 6%, which leaves you with a yearly phantom loss of 3% you could be earning. When you try to sell the bond, the reality of the loss appears: investors may pay you 15% less for your bond than you paid for it since it has a poor yield compared to the going rates.

Investors try to avoid interest rate risk by keeping their money in shorter-term bonds and cash. Earning three percentage points less than the going rate isn't as painful if it only lasts a year or two. Another strategy – one that proved disastrous in the last crash – was to own adjustable-rate debt (including mortgage debt) that adjusts up if yields rise. Sadly, when rates rise, default risk, which is worse than interest rate risk, comes back into play. Another strategy is to own higher-yield junk bonds. When rates rise, they lose less money than safe, lower-yield government debt. 

We believe this fear of interest rate risk is a bit overblown given how low short-term rates, the alternative for dodging interest rate risk, are today. If you own a bond index fund yielding around 4%, you'll likely lose about 6% of the fund's value for every 1% rise in interest rates. If interest rates rise 3% over the next five years, you may fare better than someone invested in no-yield cash — unless short-term rates skyrocket, since the yield you earn on the bonds partially offsets the loss from rising rates. Then there's all that yield if rates don't rise, and the boost you'll get if rates fall (which, of course, no one is forecasting, just as no one predicted that home prices would slide or the economy would rebound...).

And what about all of the money on the sidelines? If ten-year government bonds drifted up from around 4% to 6%, a good chunk of that money would move into bonds in order to lock in the higher rates, unless investors get scared rates are going back to 10% – an unlikely scenario. 

If rates go up more than a percent or two, only those remaining in the shortest, safest investments will fare well. Those in junk bonds and higher-risk debt will be staring down the barrel of our old friend Default Risk. And will stocks magically do well when you can lock in 8% on a ten-year government bond? Dividend yields on the S&P 500 are hovering around 2% today. And most importantly, what will happen to real estate if 30-year mortgages go from around 5% to 9%? 

There are many things to fear from sharply rising rates. Losing a small percentage of your money on intermediate-term government bonds is the very least of your problems. Our strategy? If investors fear default, we take on junk bonds. If investors fear interest rate increases, we take on more interest rate risk. Today investor fear is shifting back to greed, so we will be moving away from more economically sensitive fund categories.