WEEKLY ECONOMIC ANALYSIS: September 19th, 2009

Provided by TEAM Financial Services

"We believe the effect of the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or financial system."
- Ben Bernanke, May 17th, 2007

Items for discussion

Bubbles here, bubbles there.....bubbles everywhere. Each asset bubble of the past 15 years has been followed by an explosion in liquidity created by global central bankers. It appears so far this year that the latest version of inflating a new bubble is occurring in the bond market. Retail investors have begun to reverse the redemptions of over $251 billion in mutual funds that occurred during the 2nd half of 2008. Through August, $226 billion has been invested into mutual funds, according to Morningstar. However, the majority of this money has been invested in bond mutual funds. Pimco Total Return (PTTRX) is now the largest mutual fund in the country by a large margin, with over $177.5 billion in assets managed. That number is truly staggering, as this single fund now accounts for about 13% of the taxable bond mutual fund market.

TEAM finds these developments interesting for a variety of reasons. First, interest rates have been in secular decline for almost 30 years. With intermediate and long term high quality bonds now yielding low to mid single digits, the only way one could expect decent returns holding the bonds would be if the US suffers a horrendous deflationary collapse. We simply do not see that scenario as being likely. Therefore, as retail investors are apt to do, TEAM believes they are running fool speed ahead directly into an oncoming freight train.

We referenced our concerns over the morality of the Federal Reserve’s policy to peg interest rates so low and how it has encouraged, if not forced, many otherwise conservative savers to move out the risk spectrum out of desperation.

TEAM believes much of these retail flows into bonds have been the result of fleeing low or zero yielding money market funds in search for higher yields. This trend has become self-reinforcing as bonds have rallied as a result and accrued significant capital gains in addition to the better yields. Of course, as bond prices rally yields fall, so those adding money over time are getting an increasingly worse risk/reward profile.

One could question how stocks could be up so much if so much money is flowing into bonds? One of the characteristics of the market rally since March has been a historic lack of volume – i.e. the move higher has not occurred with the typical explosion in volume during the initial stages of a new bull market. TEAM believes the sharp move higher has been a product of three factors.

First, sellers truly exhausted themselves on an intermediate term basis during the October 2008-March 2009 period. If sellers are exhausted enough, then even tepid demand can thrust prices higher.

Second, many short sellers we know of who have been successful long term have abandoned shorting out of fear of the impact of the vast amount of money being printed globally. One prominent global investor who we hold in very high esteem, Jim Rogers, recently stated in public that he has zero shorts for the first time in many years. This relative absence of short sellers has likely removed a typical source of supply as the market has moved higher.

This also likely means that there is a vacuum developing below the market, as the absence of short sellers will remove a critical source of DEMAND when prices eventually do head lower. This was very evident last fall when the government outlawed the shorting of certain financial stocks. Once the initial pop concluded and shorts were absent, the share prices went into free fall – government bureaucrats strike again!

Third, equity fund managers have reduced the amount they hold in cash back to extremely low levels. After raising cash levels significantly last year to lower risk and meet investor redemptions, managers are now under massive pressure to keep up with the broad market. We’ve heard/read numerous accounts of “professional” fund managers who are buying stock as fast as they can, not because they think it is the wise thing to do, but because the management of their firm has told them to do so – or else.

Market/Economic Climate

The great irony with these developments is that our gauge of aggregate investor sentiment remains far more bullish than the aggregate sentiment on the economy. TEAM expects this divergence to invert sometime in the next three to six months. We are in the very awkward position of being amongst the most bullish forecasters for the economy over the next six to nine months. For long time clients/readers who have suffered through our weekly diatribe about the coming financial/economic apocalypse for many years, they may be questioning whether we’ve recently joined the cannabis appreciation society. One of the lessons we learned from 2003-2007 was that long term fundamental concerns do not necessarily prevent short and intermediate term cycles to develop.

As we’ve been expressing in recent weeks, our bullish economic forecast is very much time sensitive. We do not expect the recovery to be a long one or one that remains strong for an extended period. While we expect the early stages to shock many as to how sharp it will be, we also expect this surprise to shift many to adopt a more optimistic, and likely wrong, longer term outlook. One question we’ve been considering is how financial markets would react if 1st quarter 2010 GDP develops at 7%+? How with the bond market react, with the Federal Reserve fixated at keeping short term rates near 0%? How with global currency markets react with most global interest rates in low to mid single digits?

TEAM believes that the next bearish development for the stock market will be a growth shock. Given the massive amount of government intervention in the “Weekend at Bernie’s economy”, what happens when investors begin to question to wisdom of record deficits and 0% interest rates with the economy growing at a rapid pace. The Fed may argue that they are just being cautious for fear of committing the same “mistake” they believe was committed in 1937 in the US and the early/mid 1990’s in Japan. We’d expect markets to greet such complacency with displeasure for fear of the inflationary genie being left out of the bottle. If the Fed decides, or is forced by markets, to tighten liquidity, then will Bernie collapse under his own weight

Just as TEAM worried that the Fed had painted itself into a dangerous corner in 2005-2007, we see yet another episode of this long running mini-series. The series has gone global, with central banks across the world facing similar issues. Given the complexity of the situation and political forces in play, our confidence in a perfect landing for any “exit strategy” is extremely low. However, we expect these issues to remain on the back burner until the potential growth surprise clunks investors on the head sometime late this year or early next. When they do, we expect many of the retail bond investors this year will live to regret their decision to chase yield.

Humor for the Weekend (From last week)

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.