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09.29.03
Doug is or at least I thought he was, a bond investor. Personality wise, he is often over the top, but he seemed to hold onto a conservative approach when it came to his money or at least those dollars destined for his retirement. Bumping into him the other day while I was watering my wife's garden (late September and the NorthWest is turning in 95 degree temperatures), I had to ask. I wanted to know if he rode out the bond downturn; whether he had shifted his positions; what he was thinking.
I was disappointed to find out that he had switched from bonds to mutual funds as he put it, "just when mutual funds were being skewered in the news". He shrugged his shoulders in a can't win-for-losing manner and headed off. I thought bond investors were long termers, so to speak, shuffling among bonds and bond funds, looking for deals, laddering their portfolios. I was surprised to find out that this is too often the case among the average investor, creating an atmosphere of frenetic outlooks and frantic trades.
Why does this happen? What prompts folks to desert a discipline that can continue to earn them money?
Let me tell you a little story first about investing.
The owner of the local corner market noticed Little Johnny start hanging out his store. The owner didn't know what Little Johnny's problem was, but the boys would constantly tease him. They would always comment that he was two bricks shy of a load, or two pickles short of a barrel. To prove it, sometimes they would offer Little Johnny his choice between a nickel (5 cents) and a dime (10 cents) and John would always take the nickel - they said, because it was bigger.
One day after Little Johnny grabbed the nickel, the store owner took him aside and said, "Johnny, those boys are making fun of you. They think you don't know the dime is worth more than the nickel. Are you grabbing the nickel because it's bigger, or what?" Slowly, Little Johnny turned toward the store owner and a big grin appeared on his face and he said, "Well, if I took the dime, they'd stop doing it, and so far I have saved $20!"
In the face of guaranteed returns, in zero-coupon bonds, Treasuries, and Treasury Inflation Protected Securities, the conservative investor has looked at the outsized gains mutual fund and stock investors have received of late and have grown envious. Moving their money around has caused a surge in equities that hides the underlying weakness in this market.
Let's begin with the dollar. It really will remain stable in the long run. Horizons short enough to fall into the period starting now until election time next year might find it difficult to stay put, but any dips in strength will be a result of a muddled policy without a clear voice. That policy favoring a weaker dollar without saying so out loud will do more damage to this economic recovery than I believe Mr. Snow, the Secretary of the Treasury realizes. The domino effect of such policy may be too blurred to see from where he is standing, most recently in Dubai.
With a weak dollar, imports cost more and let's face facts, we are importers these days, not exporters (unless you count jobs among exportable goods). Rising import prices add to the inflation many of us are feeling. Inflation is good for bondholders I would imagine increasing the opportunity to buy higher yield, lower priced issues.
I mention jobs in passing and that is probably not a good thing. The unemployment picture will not improve even as benefits begin to run out. The fragile state of this recovery is evident in the continued numbers of jobless and disparaged. Many businesses have reached a limit to the amount of employees they can jettison safely to protect a tenuous profit picture.
But bondholders have pumped enormous amounts of cash into the markets at precisely the wrong time. You would think they would simply know better, not bowing to the same emotional pressures that equity investors experience. Take away outsized returns in bonds and they are willing to board another leaky vessel.
Historically, September and October are bad months for equities. I have no reason to believe that that pattern will not continue. Folks are receiving their tax bills in the mail as you read this. Sticker shock will set in at the increases many local and state governments are requiring in order to offset years of poor fiscal discipline.
Mutual funds are about to take some profits off the table as their fiscal year ends on the 31st of October. This year especially will be difficult for these managers, many of whom are starting to show some real gains. Those returns will be heavily taxed though making investors skittish about equities as they begin to readjust themselves in November.
I will say this much about bondholders, they tried to purchase stocks that had something of value in them. In many cases, they unwittingly indexed their bets, a growing problem among stock mutual funds that claim to be actively managed. Staying close to an index like a dog on a short leash, fund managers have found that they can't get hurt too awfully bad if the market turns sour. Hanging out with the benchmark flies in the face of bullish sentiment from just about everyone you hear these days. Which leaves this recent run-up in the market at the whim of the speculators, those champions of trading without fundamentals.
It will not be the strength (or weakness) of the dollar and the subsequent trade deficits that will follow. It will not be the recovery or the lack of jobs to support it. It will not be the rising costs of living in this country. What will have the largest effect on available investment dollars is the belief that stability is not only possible but fashionable.
We have market of indexed investors holding companies that move in lock step with one another. With everyone else buying crazy valuations in companies that are low in profits and high in pension assumptions, a rush out of any kind of downturn in the coming weeks would be disasterous. In the attempt to recover ground lost in the previous three years, we may have set ourselves up for another accident.
Former bondholders like Doug worry me. These new equity investors will not be able to stomach a double percentage point drop as markets adjust. If they flee after having bought in at the top, they will create a downturn similar to those we experienced in the two previous years. All the little Johnny's and Doug's who jumped from a steady income to a volatile return are the hinge on this market. No longer pleased with a nickel they have instead asked for a quarter. That simply won't happen.
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