Don't Get Crushed by This $376 Billion Bubble

Wall Street may be to blame for the last bubble, but this new bubble is all our fault, people. And we're going to pay for it.

I'm talking about the bubble in bond funds.

Fool me once ...
Individual investors are disenchanted with the stock market. I get it. What was preached as the place to park your money for the long term just underwent a decade of negative returns. Purportedly "strong" companies like General Electric (NYSE:GE) and Bank of America (NYSE:BAC) were nearly taken out. It hurts. It burns. It makes you want to run for your life and never touch stocks again. That's the attitude many investors took.

But every dollar yanked from the stock market needed a new home. Since bank accounts achieve nothing, and the space under your mattress even less so, this homeless cash charged bum-rush-style into what seemed like the best alternative: bond funds.

And why not? Bonds are safer than stocks, our college professors told us. Gentlemen prefer bonds, the history books tell us. You want to play it safe, you stick with bonds, right?

Not this time
If there's one golden rule to investing, it's this: Any asset can become overpriced, underscrutinized, and excessively loved. It happens over and over again, and it invariably leads to the same result: The most loved assets lead to terrible long-term returns.

To get an understanding of how much love has shifted from equity funds to bond funds over the past three years, consider this table:

Source: Investment Company Institute.

Focus on the $233 billion mad dash out of equities in 2008, and the even larger $376 billion charge into bond funds last year. This see-sawing tells us that there's more euphoria in bond funds today than there was panic in stock funds during 2008. Indeed, last year's bond inflows more than doubled the previous all-time record set in 2002.

Never met a bubble they didn't love

Now, bonds had a terrible 2008, so 2009's rush was partially chasing after a great opportunity. This wasn't all dumb, blindfolded money. But there's reason aplenty to believe the bond bonanza has gone too far:

• In late January, the yield on one-month Treasury bills turned negative for the first time since last March. There's so much demand for bonds that investors are willing to deliberately lose money. Seriously.
• The spread between corporate bonds and long-term Treasuries might look generous today. But the Federal Reserve purchased hundreds of billions of dollars worth of Treasuries over the past year. That kept Treasuries' yields down substantially. So the actual spread on corporate bonds is probably tighter. Translation: Bonds are more expensive than they look.
• The Wall Street Journal recently reported that "it has become more expensive to buy protection for the debt of a range of countries than it is to purchase similar protection for some companies in those nations." This could be because investors are worried about federal deficits and sovereign debt overload. Or it could be because they're unreasonably optimistic on corporate debt. Take your pick.

But beyond these anecdotes, the obvious threat hanging over bonds is interest rates.

We're in a unique situation right now: The Federal Reserve has short-term interest rates pegged at zero, and it just finished purchasing trillions of dollars of longer-dated fixed-income assets (like mortgage-backed securities). Add that it an economy on the mend, and you have a solid foundation for interest rates that are very likely to rise, and in some cases are mathematically barred from going lower. And since bond prices are inversely correlated with interest rates, prices go down when rates go up.

Translated in English: Interest rates will rise. Bonds are bound to fall. Yet investors are flocking to them in unprecedented droves, where they'll be met with long-term returns approaching bupkis.

What to do, what to do...
Rather than driving headlong into bonds, where should investors put their money? For me, the choice is easy. I favor large-cap, high-quality stocks with:

• High dividends.
• Moats that create pricing power.
• Businesses that don't rely on discretionary spending.

Here are five I've got in mind:

You could counter that rising interest rates hurt stocks and bonds alike. This is true in most cases. But all five companies listed here have pricing power. They can liberally increase prices when need be, combating the effects of inflation and rising interest rates. Bonds can't.

That's one of the main theories our Motley Fool Income Investor service stands behind. The team picks two dividend stocks per month, tells you why they think they'll outperform, and lets you banter back and forth with both the analysts and thousands of fellow investors. To date, the team's picks have outperformed broad market indices by more than 7 percentage points per pick. Click here for a free 30-day trial. There's no obligation to subscribe.

Fool contributor Morgan Housel owns shares of Altria and Verizon. Southern Company is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.