Thursday, December 16, 2004


I am and have been a bond bear for weeks on end. Based on historical norms, the economy is too strong relative to a ten year yield of 4.2%. The nominal GNP is growing that fast! The implication is that the true inflation is almost 0!

Another interpretation is that the economy is about to slow and another is that the dollar will fall quite a bit more. What do the data say?

Recent data suggest that the dollar could go lower. The trade deficit is large. The average work week in America has softened. New orders for manufactured goods has come off the recent peak. Vendor performance has improved significantly and the yield curve although still very positive has flattened. Manufacturers are keeping inventories extremely lean. Consumer expectations are moderate and, indeed, recent polls show that more Americans believe the economy has been getting worse than believe it is getting better (They are almost correct in the very short term! Except that we are really talking about the second derivative or the rate of change). The feds favorite measure of inflation indicates that inflation is only about 1.5%.

I am a bond bear but who or what is slowing this horse down? The above numbers would lead one to believe that bonds are set to rally from here! Even the ratio of commodity prices to bond rates suggest that bonds are a buy!

In a speech today, The President of the United States suggested that his second term will be one of fiscal conservatism. He is correctly attacking the unfunded liability of the Social Security Fund as a fiscal problem that needs to be fixed. He is trying to get out in front of the na na na nas who are dying to whine that borrowing money is a sorry way to fix a deficit. (The na na na nas do not want to fix the problem, they enjoy the chorus of na na na.)

Bush continues to talk about fixing Social Security, tort law reform, tax breaks to rationalize our economy and balancing the budget; not to mention fighting the war on terrorism. He reminds of the juggler that used to be on the Ed Sullivan show. This clown could bounce several balls with one foot while jumping up and down on the other while balancing a spinning plate on a poll held in his mouth while dealing a bridge hand. It seems impossible until you witness it.

Maybe the market believes that Bush is going to practice the old political game of taking the bad medicine in the first year. Presidents do this in order to have a strong economy by the time the next presidential election year comes around. Maybe Bush believes he will need to spend the first year or more balancing the budgets in order to create a crises that can be fixed by the fiscal stimulus of passing Social Security reform.

No doubt it will take a lot of tit for tat to get SSN reform through the congress. Polls show that young folks want a better return on their money and old folks want to know that they will be protected. No matter how you slice it, moving 2 Trillion to the stock markets should stimulate the markets. The trick will be to buy the stocks before the reform goes through.

Under the circumstances, what should an investor do?

Buy solid stocks now and be willing to hold on even if there is a correction during 2005. The risks of being out of this market are bigger than the risks of being in it. If indeed there is a bond market rally, the stock market will be even more attractive on a relative basis. Even using the feds inflation gage, short rates are still stimulative. The chances of a serious slow down or recession are remote.

Finally please consider the idea that it is not that the US needs to slow down but that Europeans and others need to speed up. Unemployment in Germany, Spain, Belgium and France is 9.9% or higher. The entire Euro area has averaged 8.9% unemployment for the last full year. Euro GDP growth is an anemic 1.8% versus a robust 4% in the US.

Ironically, Americans are buying foreign stocks. There is nothing wrong with diversifying your portfolio with foreign stocks. The answer is to remember to zig when others zag. Buy large American companies now and hold. Returns in 2005 are likely to be 15% or better.