Letter - July 2003





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Bonds for Safety

Although many investors consider bonds just for stuffing into pension funds and the portfolios of widows and orphans, they are, in fact, the backbone of the capitalistic system. In dollar terms, the value of bonds outstanding far outweighs equities. Once upon a time, not so long ago, it was taught that when interest rates rose equities prices declined and visa versa. Booms (economic excesses) were brought under control by rising interest rates and recessions ended by the injection of cheap money into the economy. Unfortunately, for stock market bulls, that cycle seems to have been broken. The bears liken the current monetary stimulation to pushing on a string.

The latter cite that in the past three years, the Federal Funds rate (the Fed’s target) has fallen from 6.25% to 1%, with a mixed effect on the domestic economy. Although the consumer has risen to the bait, the business community sits on its hands. A cheap and plentiful supply of mortgage money has fueled a housing boom and the SUV market, but business refuses to follow suit. You can offer a businessman cheap money, but you can’t force him to spend it.

What we have today is an eight cylinder economy firing on four cylinders even though there is plenty of “gas” in the tank. Fed Chairman, Alan Greenspan, has opened the spigot on the money supply, which has been growing at 8% annually, and with no place to go. Investors looking to preserve capital have little choice but to park their idle cash in money market funds or T-bills, both yielding about 1%. Stock brokers are enviously eyeing this horde, but apparently John Q. Public is smarter than we are.

The recent rally in the stock market is proving difficult to sustain. Even so, we remain cautious rather than negative, except in the area of fixed income securities, which we have advised clients to steer clear of. We suspect that the bond rally which began in 1983 when government ten-year notes yielded close to 14% (today’s figure 4%) is drawing to an end. In the face of a quantum jump in both private and public debt plus the possibility of an economic resurgence, there should be upward pressure on interest rates. When interest rates rise, investors tend to overlook the downside leverage in their bond holdings. To illustrate the “sneak-up” loss possibility, our Director of Research, Sumner Gerard , CFA, has prepared an interesting example.

Philip Herzig

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