Friday, December 19, 2008

A New Bubble

Our economy does not seem to be able to get out of the habit of lurching from one bubble to the next. This, "nothing succeeds like excess," approach makes life difficult in the transitions. We had Technology, Real Estate and now US Government bonds are entering bubblelonia. When a bond fund such as the iShares ETF which tracks the long term bond market moves upward 30% in five weeks, it gets my attention.

How long will investors or even sovereign nations be willing to accept 30 year yields of 2 1/2%? I suspect not very long. Putting money in a mattress is not a long term global strategy if one assumes commerce has a future.

The TIPS market (Treasury Inflation Protected Securities) is discounting five years of deflation. Tax-Free, pre-refunded municipal bonds backed by the US Government are paying returns higher than treasury bonds and without tax. The spread (interest rates over treasuries) on corporate bonds is 3.5 times the average of the past forty years and at the highest levels since the depression.

A little perspective is in order. During the Great Depression, when the United States gross domestic product fell 25%, the default rate on investment grade bonds was 4%. Currently the corporate bond market is discounting (allowing for) a 30% default rate.

The Fed's move to quantitative easing and purchase of debt across the quality spectrum eventually, I believe, will move into corporate debt to unclog the credit markets.

I do not presume to know when this bubble will burst. The government's need to raise $1.5 to $2 trillion in 2009 makes one expect that long dated treasury rates will continue to be under pressure....until they are not. The whisper numbers for fourth quarter GDP are around a negative 6%, so upward pressure on interest rates is not yet in sight.

It seems that fear of yet another shoe to drop is keeping flight to safety the watch word in both equity and fixed income markets. I would put myself in that camp as well. My concerns include disturbingly bad reports to come from financial companies as they incur more balance sheet impairment due to lower values on debt assets on the books. Later in the quarter I expect additional pressure on hedge funds as they open redemptions again and need to raise cash (ala Madoff) and find illiquid asset valuations, previously undisclosed, revealed in the cash raising exercise.

There is, I believe, value to be found in extremes in both bond and stock markets presently, but we should move very carefully since the tide is still going out, and we don't yet know who might still be standing naked, unrevealed, in the water.

John Barnyak