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Buffett hints at bond bubble

October 5, 2010, 5:57 PM UTC

Investors buying bonds at the prevailing high prices are ‘making a mistake,’ billionaire investor Warren Buffett said.

Buffett, speaking Tuesday at Fortune’s Most Powerful Women Summit in Washington, said it’s “quite clear stocks are cheaper than bonds” now. He added that he “can’t imagine” the rationale for adding bonds to your portfolio at current prices.

Reversal of fortune ahead?

The Berkshire Hathaway chief made the remarks in an interview with Fortune’s Carol Loomis at the 12th annual summit. He said in response to a question by Abby Joseph Cohen of Goldman Sachs that investors will eventually regain confidence in the stock market – but he can’t say when.

Investors holding blue-chip stocks over the past decade have lost money, and funds have flowed out of equity mutual funds every week since the May 6 flash crash. The S&P 500 is trading in line with 1998 prices even though the operating earnings of consitutent companies have roughly doubled, says Ed Cowart of Eagle Asset Management in St. Petersburg, Fla.

The flip side of the lack of confidence in stocks is an overextended bull market in fixed-income securities, Buffett said. The yield on the 10-year Treasury note has tumbled to 2.47% from 4% in the past six months, as investors have begun to accept the notion that economic growth will be weak for years and the Federal Reserve has promised to suppress interest rates to keep a soft recovery moving forward.

The soaring bond prices have prompted some bulls to pull in their horns, and Buffett indicated he believes the risk-reward tradeoff on bond purchases at current prices isn’t good.

For one thing, he said that while he believes the economy will recover over time, the reflationary policies of the Federal Reserve will have to be reckoned with sooner or later. That reckoning isn’t likely to be a happy one for those who locked their funds up for the long haul in bonds yielding just a small percent.

“We are following policies that unless changed will eventually lead to lots of inflation down the road,” said Buffett. “We have started down a path you don’t want to go down.”