Sunday, January 6, 2013

2013 Outlook Part 3: How Did We Get Here?

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

The current debt cycle has been coined by many as "the debt super cycle." It is a 70 year event in the making that is now at its final stages. Bonds today are at the highest price in history at a time when they are extremely dangerous based on fundamentals.

How did we get here?

The starting point for the debt super cycle began on April 29, 1945 when Germany surrendered to conclude World War II. Post war periods saw the debts accumulated paid down from the victors from the countries on the losing side. Usually these countries paid as much as they could and then had to default on the rest (following WWI, Germany decided to “print” the debts it owed creating one of the most notorious hyperinflations in history – that process will soon repeat itself again).

The conclusion of the second World War was the last time the debts of world were “balanced” in any major way. Imbalances begin to build soon after and continued for the next few decades with the United States owing the rest of the world a large portion of gold in order to make good on their IOU’s. In order to keep the gold within the borders of the US, President Nixon took the world off the gold standard in August 1971 (a move that will be looked back on as wise for the US and disastrous for the rest of the world when we reach the final endgame to this story). This allowed the US to pay its debts with paper IOU’s and it allowed every government around the world to run debt and print new currency with absolutely no limit.

This was the first major event that “pushed back” the day of reckoning on the debt super cycle. In the decades since that August of 1971, we have witnessed a combination of both fiscal and monetary policy working in tandem to push back the day of reckoning as far as possible. A walk through of how the United States handled the "push back" (other countries have followed a similar path) goes as follows:

While the Fed was fighting inflation in the early 1980’s, it was the government that ran massive deficit spending stimulus programs to keep the economy churning. When inflation had been cleansed it was time for the Fed to take over in the 1990’s and they stepped in every step of the way to stimulate the markets. During this period, it allowed the government to take a break, balance its budget, and even run a surplus in the late 1990’s/early 2000’s.

In 2000, we reached the point where both the Fed and the government had to work simultaneously to keep the day of reckoning from arriving. Beginning in 2001, the Fed slashed interest rates to 1%, flooding the economy with cheap money. The government came in and announced massive tax cuts and stimulus programs that would be financed with deficit spending. The crisis was pushed back.

From 2008 to present day we have seen the same program enacted, only this time on steroids. The Fed not only has brought interest rates to 0%, but they have promised an additional $1 trillion plus QE program “forever.” The government now runs $1 trillion plus annual deficits and the consensus is that any slow down in the economy should be met with additional printing and additional deficit spending.

The Secular Bond Market Cycle:

In the late 1970’s as the previous secular bond bear market was winding down its 30 year cycle, bonds were known as "certificates of confiscation." They were the most hated investment on the planet. This was at a time when many safer longer dated bonds paid close to 20%.

Investors assumed that inflation would keep rising forever and bonds would never provide the protection needed to cover the rising cost of living. They also assumed that interest rates would rise on bonds forever meaning prices would just continue to go down. Pessimism toward the bond market was at its highest point in history. Investors at the time, which most people cannot remember, wanted to own something called gold which was entering its mania stage of the 1970's bull run. There were lines around precious metals shops filled with buyers, just as investors are lined up electronically today to put 401k money as quickly as possible into a bond fund.

Back in the late 1970’s, financial analysts used to review the US money supply on a weekly basis. If the monetary base rose, bond prices would sell-off. Why? Because an increase in the money supply dilutes the value of the underlying currency. This means you will be paid out your principle with devalued dollars in the future if the money supply is rising.

Today, a new QE program (massive printed money injection) is greeted with a surge in bond prices. This paradox is striking for those that have studied history or those that were fortunate enough to have lived through and remember the past. Fundamentally, bond prices should plunge at the announcement of every QE program but the exact opposite occurs (or has so far). Why? Because investors believe that they can front run the Fed’s purchases and sell quickly enough to be the first one out of the burning theater when it catches fire. The market today consists of hot money from professional investors with their trigger on the sell button combined with the cattle herd of middle class investors sitting in the large slow funds waiting for slaughter.

How was the middle-class average investor once again duped?

A large percentage of stock market investors lost faith in the market after the 2000 crash. Some of them crept back into stocks leading up to 2008 only to find themselves crushed again. Many people in this generation will not ever be returning to the stock market. Why? Psychologically the fear of loss is always greater than the desire for gain. In addition, events that occur more recently, known as “recency,” have a much greater impact on people’s decision making.

Some of those that ventured out of the stock market in 2000 decided to test the waters elsewhere. Their capital found a home in real estate. This market, just as they were told with stocks, "would continue to rise forever." In 2007, they were slaughtered.

Now money has moved from real estate and stocks to bonds. The TIC flows show how 401k money is being allocated - a steady selling of stock funds since 2008 and a steady buying of bond funds.

The fear of loss is amplified to an even greater degree the closer one gets to retirement. Someone in their 20’s cares much less about their small amount of capital being hurt in the short term by another stock market crash. But what about someone that is in their early 60’s looking to retire in the next few years? If they were to put their money back into stocks only to find another crash waiting for them, it would devastate their retirement portfolio.

These people have now put their money into the one investment they know and have been told "never goes down in price", bonds. They may be getting a small return on their money, but they know that at least their money will be there waiting for them. As the debt super cycle begins the process of unwinding and this mania moves back in line with reality, investors will once again learn their lesson the hardest way possible.

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