Thursday, January 28, 2010

That's another fine mess.....

Lately, well, more than just lately, I’ve been trying to find value somewhere in any market. Stocks, bonds, commodities, and I don’t see much at all. But I am not alone.

After the Fed has created over a trillion dollars out of thin air, and all asset classes have ramped up, there’s not much left. In a recovery that is almost entirely government based it still doesn’t look like a self sustaining recovery. Much like 2005 to 2007, institutional investors are looking for ways to project earnings adequate to fund pensions at statutory levels.

The State of Wisconsin investment board, responsible for $78 Billion has found their new holy grail. Borrow. Use leverage to pump up returns to keep the wolf away from the door. Wisconsin is adopting a strategy of borrowing from 4% to 20% of the portfolio value to buy fixed income investments.

After becoming disillusioned with the use of hedge funds and illiquid private equity investments pension managers are scurrying to find higher returns in a disturbingly familiar way. This is how bubbles are created. And as we have heard, there is no predicting when they have run their course. The yields available in safe fixed income are too low to provide sufficient returns. So we move back up the risk ladder to find the target return.

Why these managers weren’t leveraging early last year when bonds were priced for value is a mystery. The problem is that the bond market is so vast that this bubble could continue to inflate for a couple more years in a deflationary market. So for yield, corporate bonds provide some of the answer, but with much more risk than a year ago.

Much like 2005/6 when the real estate bubble was about to blow up, global asset allocation is piling into fixed income at the end of a very long secular bull bond market. The allocation of bonds to equities remains underweight. In a deflationary environment for the next couple years bonds are still reasonable and apt to benefit from such activities as Wisconsin’s strategy which will work until it doesn’t. Then it will pop.

Stay balanced and don’t expect any free lunches in this market.

John Barnyak
Stonehouse Asset Management