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.
Please read our
important notice about these letters and the
securities they mention.