Tuesday, January 3, 2012

2012 Outlook: United States Bond Market

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

Based on the previous discussion on the stock market outlook for 2012, you may be thinking that based on the massive outflows from US stock mutual funds into US bond funds that for the first time ever the average investor has it right. After hundreds of years of being on the wrong side of the trade the story is going to finally end well for the general public.

Wrong.

Once again, and it staggers my mind to watch it take place, middle class America has taken their life savings and placed it in the absolute most dangerous location possible.

After the 2000 stock bubble burst, Americans took their money from stocks and placed it in the one place they knew it would be safe: real estate. Home prices had risen for essentially 55 years straight and most living Americans could not even remember reading about a time when prices fell. This meant that prices could not fall, and they bought homes and second homes to protect their retirement.

Then we all know what happened in 2006. Real estate prices began to collapse.

Investors, learning their lesson from the 2000 and 2008 stock market crashes knew that their money is not safe there. They also now knew that they could not trust real estate. They then now put their money in the last location they knew was safe: the bond market.

Bonds have been rising in price continuously, year after year, for over 30 years. The average living American cannot remember a time when bond prices fell. Almost any financial advisor, who the average American pays to protect their future, cannot remember a time when bond prices fell.

We have reached the final stage of the current bull market in bonds: the mania. People will look back at the prices paid today for a 5, 10, and 30 year government bond with complete amazement, just as they now look back at internet stocks in 2000 and real estate in 2006. The following shows the current interest rates on these bonds:

2 Year US Government Bond (.23%)
5 Year US Government Bond (.83%)
10 Year US Government Bond (1.88%)
30 Year US Government Bond (2.89%)

These numbers are staggering. With money flooding out of Europe in fear, it has found a home with the United States government. When interest rates on bonds rise the underlying price of the bond falls and vice-versa. It is like a see-saw

If an investor were to purchase a 10 year government bond today at 1.88% and the interest rates next year were to rise to just 4% (still way below the historical interest rate) then the investor would lose 50% of the money invested.

A topic I will continue to review through 2012 (and I hope you now understand its importance) is that the United States government is bankrupt. The balance sheet is toxic, and the government bonds should be rated junk, not AAA.

Does that seem ridiculous? Remember that the entire global financial system, the investment managers and traders who take home millions based on their "understanding" of risk models, bet everything they had with leverage on an investment called US subprime mortgages back in 2006. The rating on subprime bonds that year just hours before they collapsed? AAA.

Can prices move higher from here? Absolutely. During 1997, many of the greatest investors in the world took massive short positions on internet stocks that held sky high valuations. The stocks then soared higher for close to 4 more years, moving from bubble price territory to beyond extreme bubble priced territory. Many of the investors taking losses on their positions gave up and began to purchase internet stocks at the peak. An old saying goes that the market has the ability to stay irrational longer than you can stay solvent.

With that said, I do not believe that the US government debt bubble will burst this year. I think the European crisis and the coming crisis that is about to wash over the shores of Japan and the UK will keep investors (incorrectly) positioned in US treasuries and keep interest rates at their ridiculously low levels.

Does that mean that I want to keep my money parked there? Absolutely not. If I know that a bomb is going to go off in a building but I don’t know when, I don’t want to hang out in the building because it (probably) won’t go off for another year, especially when the return on your investment for taking the massive risk is almost zero.

So with all this turmoil in around the world, where can an investor find safety?

Next: 2012 Outlook Part 8: Gold And Silver

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