Short and Sweet

Still, even as I was urging investors to lock in gains by selling some over-valued positions, I had a surprising number of inquiries from readers who were looking for something — anything — to buy. Such is the nature of rallies, with their seemingly irresistible siren song: Buy, buy, buy even as stocks get more and more expensive.

For what it's worth, technicians tell us that bull markets are more likely to end in a burst of euphoric buying than they are in something like Monday's downdraft. I'm not a technician, and as usual make no predictions, but I pass this along as evidence that small, sudden corrections don't mean much to many prognosticators, and may even be healthy.

All the recent excitement in stocks has obscured the more modest rally in the bond market. Longer-term yields have declined even as the Federal Reserve pushed the federal-funds rate to 5.25% before pausing this summer. That's when I urged bond buyers to extend maturities slightly, to five years, to take advantage of the then-prevailing higher yields. Those higher yields have now vanished, and the yield curve is once again inverted, meaning short-term rates are higher than 10-year Treasurys. The inverted yield curve, once considered an anomaly and an almost sure-fire harbinger of recession, now seems to be neither. But this doesn't mean you should be trolling at the far end of the yield curve in a misguided effort to lock in paltry (by historical standards) long-term rates of less than 5%.

As economists have recently noted, this year's simultaneous rallies in the stock and bond markets mean that someone is wrong. The stock market is predicting robust growth and continued rising profits. The bond market is projecting slower growth, if not recession. If the stock market is right, and the economy does gain steam, then the Federal Reserve's campaign to raise rates and curb inflation may not be over, and rates are likely to rise across the spectrum. This will punish bond investors, since prices fall as yields rise, as happened during the first half of the year. If the bond market is right, and economic growth falters, stock investors are in for a rude awakening.

This dichotomy assumes that one camp is right, the other wrong. But what if the truth lies somewhere in the middle, meaning that both groups of investors had some things right and others wrong? Somehow I feel that's the more likely scenario. I have no crystal ball, but I do look to history for guidance. The past suggests that the yield curve will eventually return to the upward, "normal" position, either because the Fed cuts rates or long-term rates rise, or some combination of the two. At the same time, the economy could slow somewhat and still achieve a soft landing if not the rapid growth the stock market has recently been hoping for. When you think about it, this wouldn't be such a bad scenario, offering as it does a little something for everyone.

My musings on the yield curve are of more than academic interest, since one of the CDs I bought a year ago matured last week. If you took my advice then, creating a ladder of one-, two- and three-year CDs, then you have earned over 4% with almost no erosion of principal in what is pretty close to a risk-free investment. I urge you to continue taking advantage of this unusual combination of high rates, short maturities, and little or no risk.

With peak rates just over 5% I see no reason to go any further out on the yield curve. When I checked this week, the highest Treasury rates, 5.21%, are for one-month notes. One-year rates drop to 5%, two-year to 4.73%, and then there's a minor bump in the yield curve with three-year rates slightly higher at 4.85%. Five- and 10-year notes are at 4.55% and 30-year at 4.63%. Should you go for even shorter maturities? A one-month CD may be a good alternative to money-market funds, but it's too short for the fixed-income portion of a portfolio. Nor are short-term maturities a good idea if you suspect (as I do) that the Fed may begin to lower short-term rates next year, which would cause those high short-term rates to vanish. I stayed with my three-year ladder, buying another three-year CD with a yield of 4.85%. (You may be able to do slightly better, since I saw rates quoted online that were over 5%.)

I've been waiting now for years for long-term rates to rise. With short-term, nearly risk-free returns of close to 5%, I don't mind waiting a while longer. When longer-term rates finally do go up, I'll gradually extend those maturities.