Bond Market Casualties of the Double Dip
By Paul Lamont
August 31st, 2010
Since the Summer of 2007, we have continuously noted the similarities to the late 1920s and early 1930s. A study of financial history has given us ample warning of the credit crisis, commodity bust, 2008 Panic, subsequent recovery, and then a crash as the bear market recovery completed.
Though the story has moved at a painfully slow pace, the plot line has remained true. As you can tell from the chart below, the comparison still stands.
David Rosenberg, chief economist for Gluskin Sheff, and Albert Edwards, chief strategist of Societe General, are two in the industry who agree with our assessment.
Bond Fund Disaster
We have said that the third leg of the bear market (or ‘Double Dip’, if you prefer) of the Great Depression “was characterized by the failure of the banking system to provide credit and money for the proper functioning of the economy.”
If History warns of a collapse in lending, then a herd of investors is likely rushing in, precisely when the prudent should be rushing out. This phenomenon should not surprise our long term subscribers.
As Bloomberg reports, “investors are pouring money into bond funds similar to that of the Dot-Com mania.” And junk bonds are being issued at record pace. The chart below shows the aberration.
Some stock market bulls are using the bond market bubble as evidence to buy equities. We expect rates to go up due to default risk and not because the economy or inflation picks up. Clearly, the last credit crunch was not a reason to buy stocks.
We expect all bonds to lose value, even Treasury Bonds. Financial institutions were forced to sell Treasury Bonds for cash in the 1930s because they remained liquid. Rates shot up (see chart below from the Reserve Bank of Australia) and portfolio losses caused bankruptcies of financial institutions, companies, and regular folks.
In our February 2008 report titled Panic Time, we were concerned with hidden bank losses. One month later, Bear Stearns had collapsed. The issue is resurfacing. CLSA’s Mike Mayo says outright that “Citigroup is cooking the books” and should be investigated by the SEC. Banking analyst Meredith Whitney also reports that banks need new capital. We should expect surprise losses from the financial sector again.
Social Mood Governs Investor Appetite
At the end of our Report on December 31st 2009, we commented that we like to leave the stock market party when the attitude of the hard-partying Rolling Stones becomes popular. Five months later, we noted in the clients-only portion of our May Report; “for the first time in 16 years, the Rolling Stones top the U.K. album chart, after their reissued 1972 album "Exile On Main St" (Polydor/Universal) hit No. 1.”
"Songwriting and playing is a mood. Like the last album we did (Exile on Main St.) was basically recorded in short concentrated periods. Two weeks here, two weeks there - then another two weeks. And, similarly, all the writing was concentrated so that you get the feel of one particular period of time. Three months later it's all very different and we won't be writing the same kind of material as Goats Head Soup.” – Mick Jagger, 1974
Goats Head Soup, released in 1973, was recorded in Jamaica and ”reflected the resurgence of soul-pop and the rise of funk.” During the same period, investors’ mood was also in a funk. After the Paris Peace Accords were signed in January 1973, which ended the inflationary Vietnam War, the stock market fell 40% over the next two years. We suspect the winding down of another war will coincide with another portfolio heartbreaker.
“For a time it seemed as if perhaps the hopeful prophets at Washington were right and prosperity was coming once more and it would be well to get in on the ground floor and make up those dismal losses of 1929. But in April this brief illusion began to sicken and die. Business reaction had set in again. By the end of the sixty-day period set for recovery by the President and his Secretary of Commerce, commodity prices were going down, production indices were going down, the stock market was taking a series of painful tumbles, and hope deferred was making the American heart sick.” – Only Yesterday: An Informal History of the 1920’s. Fredrick Lewis Allen, 1931.
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