Bond market meltdown hitting rate-sensitive stocks, ETFs —

Since I started closely following the financial markets more than 16 years ago, I have seen several major interest rate cycles.

There was the Long-Term Capital Management rate-cutting mini-cycle in 1998, which was followed by several increases from 1999 through mid-2000. Ten-year Treasury note yields surged from 4.1 percent to 6.8 percent.

There was the 2001-2003 rate-cutting cycle, which pushed the Federal Funds rate down to a then-unimaginable level of 1 percent. Ten-year yields dropped all the way to 3.1 percent.

Beginning in 2004 and continuing through 2006, a lengthy series of Federal Reserve moves helped drive 10-year Treasury yields back up to 5.3 percent. And of course, the current cycle started in 2007, with 10-year yields plunging all the way to 1.39 percent on the back of funds rate cuts and multiple rounds of quantitative easing.

What I’ve found over these volatile times is that many stocks, funds, and ETFs follow a predictable pattern from cycle to cycle. And now that rates are rising again — despite the Fed’s best efforts to prevent that from happening — I believe we may be very close to the next major shift in performance.

The question is: Are YOU prepared?

Understanding how interest rates, stocks, and ETFs

interact is crucial to successful investing!

Let’s face it: Interest rates can rise for a lot of reasons. Yields on a particular company’s bonds can surge due to a rise in credit risk, something that has happened recently to J.C. Penney (JCP). Yields on a country’s bonds can rocket because of concerns about its economy, debts, and deficits, something that has happened to Greece, Portugal, and Italy in recent years.

But one of the most common reasons for rates to rise is a fairly simple one: The economy gets better, and that boosts inflation risk. I believe that when that happens, rate-sensitive stocks and select ETFs behave in a fairly predictable pattern.

An improving economy generally pushes interest rates higher.

Early on in the rise, almost everything goes up because money is rotating out of bonds and in to stocks. That rising tide lifts all boats, including rate-sensitive sectors and stocks. But once rates rise far enough, fast enough, and for long enough, investors start eyeing the exits. They start wondering “Hmmm, maybe rates are reaching a level that will actually hurt the prospects for certain companies.”

When that happens, you start seeing those rate-sensitive stocks and ETFs get “heavy.” They don’t rise as much on up days for the market, and they drop more on down days. They put in a series of lower highs, and eventually, they can break down entirely. At the same time, money rotates into non-rate-sensitive stocks and sectors. After all, the economic improvement that’s driving rates higher also boosts the earnings prospects of those companies.

The key to successful investing is to watch for signs that this is taking place, and then take action. Specifically, you want to get OUT of stocks and sectors that will likely underperform as rates rise, and get IN to those likely to pick up the baton and keep running!

The Single-Most Vulnerable Sector Out There?

So what sector is the most vulnerable? I’d have to put the bullseye on real estate, housing, and mortgage stocks. These guys had a tremendous run in 2012 because mortgage rates were pegged to the floor and some “core” housing demand picked up.

Layered on top of that has been a tremendous influx of big, fast, (and in some cases, dumb) money chasing the latest trend in real estate. That trend? Buying homes and condos for cash, then turning around and renting them out to generate more yield than you can get from Treasuries or other bonds.

In the early going, those investor purchases helped absorb some distressed inventory with little negative impact. But as time has gone on, more and more of these buyers have poured into the market with little regard for the fundamentals.

They’re desperately out-bidding each other, driving house prices up at double-digit rates in many markets. That’s occurring even as mortgage rates are hitting their highest levels in several months, and even as wages, economic growth, and job creation are failing to keep pace with the price gains.

Long story short?

Yes, I believe that housing has “turned” for the long term. But I also believe the stocks and pricing have gotten ahead of themselves. At this stage, based on everything I’ve seen in more than a decade-and-a-half of watching interest rate cycles, I believe they’re poised to flatten out in the best case — or potentially fall on their face if rates really accelerate to the upside. So I’d stay away from almost every stock in the housing and mortgage sectors.

REITs also tend to trade in line with residential real estate, even though many sector companies are involved in the commercial side of the business. So I would get out of most of those, too! Then I would take that money and put it in the “bond alternatives” I’ve been discussing, as well as cyclical stocks like industrials or transports.

As for Bonds Themselves …

Boy are they becoming a lead anchor for investor portfolios! EMB and PCY, the two major ETFs that invest in emerging market debt? They just hit seven-month lows. TLT, the most popular long-term Treasury bond ETF? It just tanked to the lowest level in 11 months. And did you see MUB, the large municipal bond ETF? It just suffered its third major shellacking in the past year.

Even JNK and HYG, the major high-yield ETFs, are starting to underperform. They used to pretty much march higher right along with the stock market. But now, they’re starting to lag … yet another sign that rising rates are beginning to bite.

You should be completely sidestepping this carnage, of course, since I’ve been warning you to expect it for months on end here, here, and here.

I continue to counsel avoiding all of the ETFs I just listed, as well as mutual funds or individual bonds with similar levels of interest rate or “bond bubble” risk. The rest of 2013 could be just as ugly for them, if not uglier, than what we’ve seen over the past several months!

Until next time,

Mike