The bull market is almost two years old, but bond maven Kathleen Gaffney thinks stock prices should continue to rise in 2011. Beware: dangers lurk in Europe. By Steven Goldberg, Contributing Columnist December 21, 2010 Don’t expect the stock market to shoot straight up in 2011. Just as the market did this year, stocks will bounce around, frightening investors at times. But a slow-growing U.S. economy augurs well for share prices.That’s the outlook from Kathleen Gaffney, co-manager of Loomis Sayles Bond (LSBRX), a first-rate bond fund that’s a member of the Kiplinger 25. Gaffney invests almost exclusively in bonds, but I often turn to her and other bond managers for their big-picture views. Most premier stock-fund managers spend the bulk of their time studying individual companies. By contrast, almost all good bond managers first focus on forecasting the economy. Europe is likely to be racked by major problems next year, Gaffney says. Greece and Ireland are “essentially insolvent,” and Spain, Portugal and Italy face dangers, too. “When bond investors lose confidence, everything falls apart,” she says. Europeans, Gaffney adds, must concoct a new plan to resolve the continent’s fiscal crisis. She isn’t sure exactly what that plan should entail, but it needs to allow Greece and Ireland to restructure their debts: “The goal is to allow these productive, developed countries to have access to capital again.” Advertisement Will Europe’s woes spread to the U.S.? Bet against it. The more investors become fearful of their investments in euro-denominated securities, the more likely they are to seek safety in the dollar, particularly in U.S. Treasury securities. During the past couple of years, the financial markets have acted almost like a switch that has only two positions: “risk on” and “risk off.” During risk-on days, traders flock to stocks, particularly small-company stocks, as well as emerging-markets shares. They also buy high-yield corporate bonds and debt of emerging nations. On risk-off days, traders buy gold, the dollar and Treasuries. As the European crisis continues to unfold, Gaffney expects more of the same. What’s changed is that fears of a double-dip recession and deflation in the U.S. have subsided. That’s great news for U.S. stocks. However, high debt levels among consumers and all levels of government are keeping a lid on the recovery here -- and keeping the jobless rate high. Gaffney guesses that the unemployment rate will be 8.5% on Election Day 2012 (compared with 9.8% today). In emerging markets, rapid growth is likely to continue in 2011, but China and other emerging nations face growing risks that their economies may overheat, sparking inflation. “I think you’ll have very strong emerging-markets stocks and bonds, but risks are rising,” Gaffney says. “Don’t stay too long in emerging markets.” Advertisement Gaffney is bullish on commodities, especially food and other agricultural products. As the citizens of emerging nations become wealthier, they seek food with more protein and other products that they previously have been unable to afford. That’s pushing up prices for many kinds of food and agricultural commodities. “That’s what makes China really nervous.” Gaffney says. Gaffney and senior Loomis Sayles manager Dan Fuss think that bond yields hit a major bottom in 2008, tumbling to 30-year lows during the financial crisis. Since then, most yields have trended up (and bond prices, which move inversely with yields, have trended down). Given their view that yields are more likely to rise than to fall, Gaffney and Fuss are unwilling to invest in long-term bonds, which are more sensitive to changes in yields than shorter-term bonds are. But they are still willing to assume credit risk in Loomis Sayles Bond. “High-yield bonds still look pretty attractive to us,” Gaffney says. She also favors convertible securities, which are kind of a cross between stocks and bonds. Loomis Sayles Bond even owns some real estate investment trusts, high-yielding stocks that invest in commercial real estate. The fund’s average credit quality is BBB-plus, just a few notches above junk. About 30% of the fund’s assets are in junk bonds, which tend to track stock prices. Geographically, the fund has 4% of its assets in Latin America and a like amount in Asia. It has 17% in commodity-rich Canada and 6% in Australia and New Zealand, which also benefit from rising commodity prices. Advertisement Loomis Sayles Bond stumbled badly in 2008, plunging 22.1%. But it rallied 36.8% in 2009, and so far in 2010 (through December 20) has gained 11.9%. Over the past ten years, the fund returned an annualized 9.5%. But with the great bull market in bonds apparently over, don’t expect Loomis Sayles or any other fixed-income manager to put up those kinds of numbers over the next ten years. If Gaffney is right, you’ll be better off having the lion’s share of your money in stocks and stock funds in 2011. Steven T. Goldberg (bio) is an investment adviser.