BOND TRADE

Yesterday, I could not resist jumping on a 200 bond trade for a friends account. The fellow had margin power available at 4.75% interest, a 23 treasury was available at a yield of 4.91% and consumer sentiment was and is at recessionary levels.

Don't assume that I am calling for a recession. To the contrary, after a soft patch brought on by the fear of high winter heating (yes, the fear is worse than the actual event), I expect the economy to pick up strength throughout 2006. Indeed, small business owners are optimistic. Small businesses create about 90% of all new jobs so it is important to note that this group sees good times ahead.

The upcoming holiday retail season is likely to be a weak one. Consumers were hit hard by the jump in oil prices and the increase in loan rates on their variable rate loans. It is natural for consumers to get squeezed when an economic expansion gets under way but it is unusual for the squeeze to start out like a wrestling match with a boa constrictor.

Yesterday, another billion dollar oil refinery was in the news. This time it is Syria, with the aid of Russia, who is planning the plant. The same day, another company announced a huge expansion in Georgia. A billion dollar plant is the equivalent of 1,000 million dollar homes or 4,000 $250,000 homes. When you have hundreds of billion dollar facilities being built at the same time around the world, you have a squeeze on capital at hand. Should it come as a surprise today that Toll Brothers lowered their forecast for home sales? Toll Brothers and many related stocks, every thing from competitors to carpet to appliances sold off hard. The bond market took a big jump.

Please note that I made the bond play as a trade only. I expect long rates to be higher by the end of next year. I expect the Fed to raise short rates at least one more time in the near term. I think it will take two quarter point increases to finally convince the markets that inflation is not such a big problem.

Inflation expectations are just as important as inflation itself. If workers demand wage increases to "catch-up" with the cost of living, the inflation spiral can be hard to stop. This time the inflation spiral can not support itself because the global market has opened doors to billions of potential workers. Right now, the core inflation rate is low around the world. Unit labor costs increases are low partly because productivity continues at a strong pace. Inflation expectations are about to fall.

The drop in oil prices, in the past month, will gradually feed back into the headline inflation numbers and will even more gradually feed back into the core numbers. The next price declines will come in metals; copper, gold, aluminum, steel, etc. Spot prices will fall and futures prices will plummet. By the spring of 2006, I suspect the FOMC will actually have to lower short rates.

I expect to make only 5% in the bonds (it will take about a .5% decline in long rates to give me the 5%) but a $10,000 gain on borrowed money is better than finding $10,000 blowing in the wind. Caution: the inherent risk in this trade is deceptive. Ironically, the risk is not nearly as large as believed by the 40% of folks who are risk adverse and the risk is much larger than is believed by the 20% who love to take risk.

You see, about 40% of the folks in the world are "collectors", about 40% are "investors" and about 20% are "speculators". The collectors lose the most because they allow others to make money off their money. They leave money at very low rates in "not so safe" banks, they pay brokers high management fees, they pay high mutual fund fees, they pay high insurance costs and they buy what others are buying (which means they realize low market returns); once they buy a dead stock they tend to hold it for years trying to get their money back. The speculators make a lot but lose a lot and in the long run are more likely to be broke than the collectors. Investors are willing to take a business risk. Investors understand that there is a balance somewhere between default risk and inflation risk that leads to great wealth. The speculators lose a lot to default risk and the collectors lose a lot to inflation. Investors don't win on every trade but they consistently win in the long run.

In the bond trade mentioned, the risk was offset by the particulars of the portfolio involved. If the economy does well, this account is going to do very well, however, in the short run, owning a few bonds diversified the account, even though the bonds were purchased with borrowed money. Again: CAUTION: leveraging stocks or bonds to the max can be devastating to your financial health. It can be a lot of fun when you are right.