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<<I may be better off to just go with CD's and/or government bonds.>>

Going with CDs or Govt. bonds is the correct thing to do if they are going to be the best performers over the next few years. My conclusion at the moment is that long Treasuries will be the probable best performers for a while, and I've been moving into them. Here's how I analyse the situation.

The basic determinants of future stock or bond prices are as follows.

1) Rate of growth of the economy.
2) Inflation rate.
3) Present prices of stocks and bonds.

Addressing these issues one at a time we have:

1) Economic growth is caused by a very complex combination of factors, but there are a number of negative factors in play now that suggest slower growth to me. In particular, record corporate debt/GDP ratio, record personal debt/GDP ratio, industrial overcapacity, falling stock prices (which hurt corporations' ability to raise capital and tend to reduce the exuberance of consumer spending), falling global growth, high and swiftly rising Govt. debt, slowing growth and recession overseas, banking crises in Japan, Latin America, and China, and falling money supply growth in the face of lowered interest rates.

What are the factors suggesting renewed growth? I'm not sure. The personal and corporate balance sheet repair that occurs in most recessions doesn't seem to have started yet in this one. Interest rates are relatively low, and while they are stimulating home and car sales, the money supply has not been responding lately.

2) The inflation rate at the retail price level is still in a long secular downtrend, as it is in many other major economies. Japan and China have significant deflation, despite official efforts to reverse this. While my own understanding of the dynamics of price inflation is pretty crude, I do know that established price inflation trends seem to be very powerful and hard to reverse. Witness Volcker's epic (and very painful)battle at the end of the Seventies, and Japan's last decade where their Govt. has printed themselves into virtual bankruptcy with no success against deflation.

Also, I believe that the current high debt levels are deflationary, though I'm not sure why except that high debt reduces purchasing power. Any opinions on this from economists out there?

3) The S&P 500 trailing 12 month p/e ratio is now at 36, compared to the long-term average of 15. Other valuation measures like price/book ratio are all still high. All this means is that any rise in stock prices is going to start from an extremely high level, which in any sane world limits how far they can go.

Long bond prices in general however are low in terms of their real yields, i.e. their yield after inflation. How else are you going to value them except in terms of their real yields? The other main factor I am aware of in valuing bonds is the expected future movement of interest rates, which is pretty much crystal-ball stuff to me, except insofar as we can project inflation trends.

CONCLUSION. (At last!)
Putting all this together, one can reasonably expect slow growth and falling or negative inflation. Stock prices are high, bond prices are low. These conclusions lead you straight to bonds.

So, what kind of bonds? Junk bonds do best at times of strong profit growth, as corporate credit quality improves. Strike out junk for the time being. Corporates do best in a strong economy with falling rates. Not likely. TIPS are best at a time of stagflation, and are poisonous during deflation. Regular, long term Treasuries are the ideal investment in times of deflation and poor corporate profits. If inflation continues to subside, they will increase in value. Their yield is guaranteed. If we slide into a really serious downturn, no other bond investment will keep up with Treasuries, because of declining credit quality. This includes Munis, etc.

In Japan, if JGB's had been available at 5.5% yields in 1990, a person buying them at that time and still holding them now would have cleaned up. If you agree that our current situation is somewhat analogous to Japan in 1990, then Treasuries are a pretty obvious choice.

Lastly (if there is still anyone reading this long epistle), there is the valuation issue. At four percent over the inflation rate, long Treasuries are near the low end of their historical price range. I can't imagine why, unless investors have been mesmerised by the Wall St stock boosters ("is this the bottom?", "stocks are cheap" and other BS.), and are actually expecting the rapid growth and rising interest rates that Wall St has been predicting constantly all through the slowdown. Remember, this is what they predicted all through 1930 and 1931 too.

So long Treasuries have low risk, low price, high yield, and are quite likely to appreciate strongly while other investments sit still at best. Like Oliver Twist, can I have some more?

Good luck,

Ed.




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