BONDS
WINTER 2010

For the past fifteen years, interest rates have been in a cyclical decline, moving from double digit rates to rates today which are very close to zero.   Despite the decline in the income being produced by bonds over this span of time, there have been opportunities for appreciation of fixed income securities, since bond prices rise while interest rates fall.

The massive infusion of money into the economy and the banking system over the past sixteen months has changed the supply and demand characteristics for fixed income securities.   Bond managers say that the result of this is that “government intervention is keeping interest rates artificially low and left to their own devices, rates would go higher.”    Therefore, when the current conditions return to normal, interest rates have nowhere to go but up.   Dan Fuss believes that “we are in the early stages of a long term rise in interest rates.  Managers will be swimming upstream against rising interest rates”.

Credit fundamentals at federal and municipal levels are “absolutely awful” and Fuss does not think it will be possible to bring the US deficit below 4.5% of GDP, almost twice its historical level.   At a recent conference, three prominent bond managers agreed that their asset class will deliver below average and possibly negative returns over the long term.

The headwinds posed by a secular rise in interest rates will be very powerful.

Therefore, RKM is advising clients to substantially reduce the percentage of our clients’ portfolio allocated to and invested in fixed income.     Further, as we have already started doing, more of the specific investments within the bond asset class will be floating or adjustable rates securities and eventually more inflation bonds.

STOCKS

The same fifteen years that saw interest rates in cyclical decline have seen two boom and bust cycles for stocks.   During the late 1990’s and into the year 2000, we saw the technology and internet stock boom that took the Dow Jones Industrial Average above 10,000 for the first time and took the NASDAQ (right) to the unsustainable 5,000 level.   From there, we had a tech meltdown with declines in value of stocks not unlike the crash of 1929-1932.   From peak to trough, the NASDAQ, heralded at the time as the stock market of the future, dropped by 80%.

From the lows in 2003, markets around the world recovered much of the losses experienced from the tech meltdown, with many including the DJIA reaching new highs.   All seemed to point toward continued gains until the sub prime meltdown struck in 2008.   The subsequent 50% decline in most indices left investors wondering about the future of capitalism itself.   Just as many investors were ready to throw up their hands and give up, the recovery of 2009 happened.

It is a little bit too easy to see this recovery as a return to the good old days of the nineties or the middle of the decade just ended.   The problems that caused the financial meltdown last year have not been fixed, and the will to fix them has dissipated.    Banks are back to creating the same type of financially engineered products that took us to the brink of depression.   The Obama Administration, despite its mandate of change, has changed very little about our financial system.  The current Treasury Secretary is one of the major players from the past decade.   He is a creature of the system and not an agent of change.

The respected analyst, Jeremy Grantham * predicts “seven lean years” for companies around the globe, but he suggests that these seven lean years will bear less heavily on the blue chip companies.   RKM believes that only the most established global companies with solid finances, low debt, good franchises, and tested management will be above the fray this decade.  The Coca Cola’s and the Disneys of the world will not be touched as significantly by the seven lean years expected.   Asian auto companies and European pharmaceutical companies are global companies that could prosper in this environment.

REAL ESTATE/ALTERNATIVE/SPECIAL SITUATIONS

At RKM, we consider inflation hedges and alternative investments to be a separate asset class, as these investments have established performance different from traditional asset classes over time.  During much of the last fifteen years, real estate and energy have been substantial parts of our strategies here at RKM.    More recently, we have encouraged clients to establish stakes in commodities and currencies, which have provided more diversification and good returns.   In 2009, we have added timber and agricultural stocks to this class of assets, which have provided excellent returns this year.

*Grantham’s got an impressive track record when it comes to making the right investment calls…
1982: Said the U.S. stock market was ripe for a “major rally.” That year was the beginning of the longest bull run ever.
1989: Called the top of the Japanese bubble economy.
1991: Predicted the resurgence of U.S. large cap stocks.
2000: Correctly called the rallies in U.S. small cap and value stocks.
January 2000: Warned of an impending crash in technology stocks, which took place two months later.
April 2007: Said we are now seeing the first worldwide bubble in history covering all asset classes.

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