BIG BOYS--BAD BONDS--GOOD REAL ESTATE

A few days ago, Big Boy Buffet sold 3.5 Billion Bonds (see post of 1/14/2005). I never like to bet against Buffet and certainly do not intend to buy bonds now. Why are bonds so bad?

Two Bigger Boys, Federal Reserve Board Chairman Alan Greenspan and President George Bush are co-operating to make bonds bad!

The President has planned a very aggressive agenda for his second term in office. He desires to lower taxes, to fight the war on terrorism, to pass tort reform and to reform social security; all the face of a relatively slow world economy. If successful, one can infer that neither of the twin deficits will be brought back into balance anytime soon. (This does not alarm me as it does so many of you and indeed the US Economy would benefit greatly if the Bush program were to be passed.)

Can the President pull off more than a hat trick? The answer partly depends on Alan Greenspan. Greenspan is definitely playing along. Although Greenspan has raised short rates four times in the past four months, the increases have been small and came from historical lows; money is still cheap and available. The real fed funds rate (the rate minus the trailing year over year change in the PCE deflator) is now .75% (2.25%-1.5%=.75%)!

Three quarters of one percent real interest is not enough to slow the American consumer or the American business. Furthermore, it is not enough to cause the dollar to strengthen against foreign currencies. And finally it makes American home owners and stock holders happy as they watch their net worth compound. The cycle continues as consumers with additional wealth spend additional sums.

Of course, sooner or later, the stimulative effect of the lower interest rate will bite; the inflation rate will increase, long interest rates will go up and bonds will go down. Without taking the time to make a precise calculation, I can tell you that if the rate on the long term treasury bond goes up by only .1% in the entire year of 2005, the total return of the bond will be reduced by almost 1%. Call this a multiplier effect if you like but it is a powerful phenomenon. A bond that currently yields 4.4% now and a current yield of 4.5% in 12 months will have lost about 1% in value. If the rate were to go up .2% the investor would have been better off to have kept his money in a 1 year CD.

Stocks and bonds are related. They may not be like brothers and sisters but they are at least as close as first cousins. If a company fails, the bond holders and the stock holders may lose all but maybe the stock holder loses all and the bond holder recovers a bit. If inflation is really high, bonds and stocks may suffer but bonds would suffer much more than stocks. In general, stocks can tolerate inflation far better than bonds just as one cousin may eat sweet potatoes and the other says no way.

The market has traded for the past couple of weeks as if the Fed has decided or will decide to raise short rates even faster. Stocks have gone down in value, bonds have increased in value, and the US Dollar has actually showed a little strength. Greenspan may know but the rest of us can only guess if short rates are about to go up more.

On the other hand, disinflationary pressures are unusually strong. Productivity growth has been unusually strong and continued adoption of new technologies should keep this trend in tact. World trade freedom has unleashed billions of productive resources (including billions of people who work for small wages).

The classical definition of inflation as stated by Milton Friedman is that inflation is too much money chasing too few goods. In some ways, we currently have the opposite. Due to productivity and free trade, we have too many goods chasing too few dollars. The US money supply has grown year over year at about 4.2% which is about the same rate as our GNP, but European central bankers have been stingy and China has tried to engineer a slowing of their extra strong economy.

BOTTOM LINE

The US Government will continue to spend money and issue lots of bond paper.

The Fed will continue to work with the President to try to gradually lower the dollar.

The Fed may increase rates a little more but not enough to risk recession.

Corporations will enjoy low rates and low taxes and produce profit gains of 11% or more.

Inflation rates will increase slightly but will remain relatively low.

Long rates will increase by the same slight amounts of increases in the inflation rate.

Real estate and stocks will appreciate until the market "smells" a jump in long rates.

Under these circumstances, even relatively conservative investors should consider buying solid US blue chip dividend paying stocks with a portion of the funds they might normally allocate to the bond market. If you don't believe me, ask Warren Buffet!