The Best Asset in a Time of Volatility

All markets are volatile these days.  Stocks are gyrating, bonds are falling as interest rates increase, oil is bouncing up and then down, bitcoin has fallen all year, and even the real estate market seems to be going wobbly.  Gold and silver have been slipping away.  And foreign markets look even gloomier.

Investors naturally look for opportunities when prices fluctuate.  Whether you're a buyer or a short seller, price movements create the potential for profit.  Volatility is gut wrenching if you're taking losses, and can stimulate panicky selling when prices are low.  But it can be exhilarating if it looks like a lucky break.

That's why cash is often the best asset to hold in a time of volatility.  It gives you the means to take advantage of fortuitous price movements, while its stability insulates you from the emotional roller coaster that often drives people to sell when prices are dropping.  Don't think that you have to remain fully invested all the time.  What you have to do is remain unemotional, as emotion is the enemy of careful investing.  A nice, comforting cushion of cash can prevent an unwanted flood of adrenaline.

Cash may appear to have a low rate of return, with greedy banks still paying miserly rates of interest on deposits even though interest rates have been rising.  But cash also offers the potential to profit from price volatility.  You can dive into an asset when its price is low and make a bundle when it rebounds.   That potential makes the effective return from cash much higher.  So don't be afraid to hold a lot of cash in a time of volatility.  That's when it's an investor's best friend.

Is the Fed Undermining Portfolio Diversification?

A basic investment strategy for investors is to diversify.  Typically, investors put some of their money into stocks, and most of the rest into bonds.  Small portions may go into gold or other commodities, or be held as cash.  Stocks and bonds historically have tended to offset each other.  When stocks rose, bonds would fall, and vice versa.  A diversified portfolio would be hedged, ameliorating the ups and downs of the market and making investing less stressful. 

Today, though, central bank accommodation--in the form of ultra low interest rates, negative interest rates and quantitative easing--has distorted this historical relationship.  As the Fed and other central banks print more and more money, both stocks and bonds rise in value.  They no longer offset, and diversified portfolios are becoming unhedged.  If and when the era of easy money ends, both stocks and bonds could fall, and perhaps precipitously.   

By unhedging diversified portfolios, the central banks are heightening investor risks.  Many wealthy and institutional investors, apparently sensing the danger, have been increasing their levels of cash.  But ordinary mom and pop 401(k) investors may not be able to shift gears so easily.  They may face increasing exposure, and perhaps not know it.  If they sustain losses when they expected to be hedged, they could lose confidence in the markets.  The result could be rapid and ugly.  That's what happened on Black Monday, October 19, 1987, when the stock market crashed and fell 22.61% in a single day because many institutional investors thought they'd be hedged by a financial product called portfolio insurance and found out unexpectedly that portfolio insurance didn't work. 

The central banks could reduce accommodative policies in order to raise rates and normalize the financial markets.  But that process could cause investor losses and trigger selling that leads to a market meltdown.  If, on the other hand, central banks keep printing money, they may worsen the problem.  You could shift more assets to cash (or at least refrain from committing fresh cash to the markets).  Otherwise, understand that diversification, like everything else in the financial markets, is starting to look a little hinky.

The Zen of Investing

How do you allocate your investment funds in times like these?  Stocks bound upwards for a couple of days when statistical data indicates the economy is slowing or a Fed governor smiles.  Then, the market nose dives crazily the next couple of days when oil prices rise or unemployment falls or another Fed governor frowns.  Bonds slump and then surge, or surge and then slump when inflation expectations rise or fall.  One constant in the financial markets is volatility.  Another is unpredictability.  And a third is no net gains--as in, for all the hysteria, stocks have hardly done squat this year.

The financial media is full of conflicting predictions--the market will boom, the market will crash--and conflicting advice--buy this, sell that, short the world and stock up on survivalist gear.  To paraphrase former Fed Chairman Ben Bernanke, things are unusually uncertain.

At times like this, the best option may be to step back from the chaos and cleanse your mind of desire.  At least, of desire for short term gains and avoidance of losses.  It's impossible to make money all the time, or to avoid all loss.  With entropy seemingly on the increase, any effort to make every day a good market day will have you believing six impossible things before breakfast and doing battle with windmills.

There's nothing wrong with holding cash, maybe even a lot of it.  Cash is beautiful.  A goodly amount in a federally insured bank account or U.S. Treasury debt promotes equanimity and sound sleep.  You will smile more.  There may be some who would argue that a fully invested, well-diversified, periodically rebalanced portfolio will provide better returns than a partially invested portfolio with a lot of cash.  This may be true in theory, but an awful lot of investors don't have the nerve to stay the course with a fully invested portfolio through the periodic mania of the markets.  They sell and freeze up, never again to invest, and potentially lose a great deal of future gains.  All the nice theory in the world doesn't amount to diddly if you're too stressed to implement the theory.  To maximize returns in real life, you have to be calm and unemotional.  And if doing that takes having bundle of greenbacks under the mattress, then so be it.  Don't feel the need to allocate every last dollar to something or other right away.  Hold off on betting your last buck until you feel comfortable.  Be zen, and increase your chances of becoming rich.

Why You Should Invest Like the Smart Money

One characteristic of the investing strategies of the wealthy is to diversify.  Stocks, bonds, money markets, real estate, alternative investments, collectibles, precious metals, jewelry, and so on are frequently found in the portfolios of the high net worth crowd.  Diversifying is a way to win no matter what's going on with asset values, and the wealthy want to stay wealthy.

The 99% should do no different, and recent market activity illustrates why.  Bond values have improbably risen in recent weeks, while stocks are stuck in a trading range right about where they started the year.  Gold and silver went up earlier this year, but have slid back.  Real estate ended 2013 with a roaring comeback, but now seems to have stalled out in many markets.  International markets have delinked, with Asian markets generally falling over the past six months, while European markets have moved up slightly (Ukraine crisis notwithstanding).  It would not have been easy to predict this mix of events.  Indeed, it's rare to find financial analysts who predict much of anything right.  Few predicted the 2007-08 financial crisis.  Few predicted the 30% jump in stocks in 2013.  Few predicted that bonds would rise this year.

The investing patterns of the smart money reveal that the smart move is to diversify.  Don't look for a quick buck.  You'll probably get a quick loss.  Don't look to hit a home run with a single investment.  The financial press may glamorize the few who manage to do that, but generally pays little attention to the many who fail.  Don't try to predict the unpredictable.  There are rare situations, like 2008-09, when all asset classes seem to be falling in value.  That's what can happen when vast amounts of debt and other leverage enter the financial system in one-sided bets dependent on rising asset values.  When that debt begins to lose value, the assets it was used to buy are at serious risk.  But more typical is what we have today--a lot of uncertainty, but some of the uncertainty is about the upside and some about the downside.  Most of the time, diversification is the best way to play your cards. 

And if you're still unhappy about your net worth, save more.  Whether the markets are doing well or badly, adding to your pool of capital will pay off in the long run.

Why No Great Rotation?

A popular view among market aficionados is that, with bond prices falling while stocks have been rising, money would shift from bonds to stocks.  Stocks and bonds have historically often moved inversely.  When stocks rose, bonds fell, and vice versa. With bonds falling now, it would seem reasonable to expect investors to rotate their money into stocks.  But there has been no rotation.  Why not?

First, for the past five years, we've had a brave new Fed which has manipulated asset values in ways beyond historical experience.  Since early 2009, central bank easy money has helped to spur a stock rally accompanied by a bond rally.  Both asset classes rose simultaneously, instead of moving inversely.  With their traditional relationship out of whack, it is hardly surprising that they don't cha-cha when they're supposed to.  Investors would be understandably suspicious of stocks in a market that is seemingly dependent on the Fed's methadone program, especially when the Fed is talking about easing out of its role as Dr. Feelgood.

Second, the Great Rotation is an investment strategy for the medium to long term.  Today's stock market is dominated by high-speed, computerized trading, where the holding period for stocks is measured in milliseconds.  The long term human investors that might consider rotating greatly have mostly been supplanted, and many have chosen to invest on autopilot, buying index funds and throwing salt over their left shoulders.

So whither the markets?  That's the $64,000 question, and in truth nobody knows the answer.  With both stocks and bonds having enjoyed years-long bull markets, logic and experience, especially recent very painful experience, tell us that when markets can't keep rising indefinitely, they won't.

Is the Fed Losing Control?

In the past two weeks, we heard from Chairman Hyde and then Chairman Jekyll.  A couple of weeks ago, Ben Bernanke made allusions to gradually winding down the Fed's bond buying program, called quantitative easing.  Up to this point, the market had perceived the current round of QE as infinite, a perception that Fed had encouraged by placing no time limts on the program, and offering only the vaguest of guidance as to when QE might end.

But two weeks ago Chairman Hyde frowned and cleared his throat, and the bond bulls began running.  In their panic, they gored many an investor who had drank the Kool-aid however reluctantly and bought risk assets like long term Treasuries, corporate bonds and junk bonds.

Within days of Chairman Hyde's hint that the punch bowl might be taken away, the ten year Treasury note was yielding over 2.5% (up from 1.6% in May) and 30-year mortgages popped up about 1% to 4.5%.  Stocks quivered, but didn't belly flop like bonds.  Alarmed, various governors of the Fed and presidents of Federal Reserve Banks chimed in and suggested that the punch bowl wouldn't be withdrawn any time soon.  Stocks perked up, but bonds continued to pout and mortgage rates kept rising. This was emphatically not what the Fed wanted, since the Fed is resorting to its old trick of trying to revive the economy by bubbling up the housing market.  Even though this is what got us into trouble in 2007-08 with the mortgage crisis, the Fed evidently has an abiding faith in its old tricks.

With the housing rally now threatened, Chairman Jekyll spoke up this past Wednesday (July 10) and made nice nice.  The little toddler of a recovery would need propping up for a long time, he said, before he'd expect it to walk on its own--a very, very long time.  He also said he was sending the senior Fed staff out for a late night booze run to stoke up the punch bowl.

Stocks did a cheery little conga and stepped up to new heights.  This might produce a bit of a wealth effect to boost the economy.  But it will be hardly a smidgen, if the bond market doldrums continue. Bonds barely budged after Chairman Jekyll's attempted love fest.  The ten-year Treasury dallied briefly with the 2.53% level, but then went back up to 2.59%.  Mortgage rates continue to cloud the skies over the housing market. 

Is the Fed losing control?  This is really two questions.  What message is the Fed trying to send?  The most recent minutes it released indicate sharp divisions within the Open Market Committee, and the truth may be that a highly mixed message would be the most accurate.  Bernanke's initial statements two weeks ago may have been an attempt to be transparent and let the public know what the Committee really thinks.  But the Fed got what it perceived as an over-reaction from the market, and has been trying to cover its tracks ever since.

But did the Fed get an over-reaction, or an accurate reaction?  The sharp sell-off in bonds and rise in mortgage rates may have reflected the erstwhile rationality of betting on a continuing rally in fixed income.  Central banks worldwide have joined together and danced the most accommodative bunny hop in the history of banking.  Anyone who anticipated a reversion to the mean in the money markets has been just about rendered CIA-style. Much of the flash crash in the bond markets may have been hedge funds and other big players unwinding leveraged positions betting on more booze for the punch bowl.  Now that the Open Market Committee may be going wobbly on the idea of giving a drunk yet another pitcher of Martinis, bond pros evidently are becoming wary of the hair of the dog that just bit them.  If so, the Fed may have lost control of the long end of the yield curve.

If the Fed no longer has a clear message to send, and can't maneuver the long end of the yield curve any more, it may lose control of the economic recovery.  But perhaps it never really had that much control.  Maybe things looked good for a while because people wanted to believe, and the Fed provided the only federal economic policy they could believe in.  With Chairman Bernanke now a short timer, courtesy of President Obama, it's unclear what anyone can believe in.  And that won't be good for the market or the economy.

Regulatory Challenges of the Bond Market

The Great 2013 Bond Market Chain Saw Massacre has probably caused trillions of dollars of losses.  On May 1, 2013, the yield on the U.S. Treasury 10-year note went as low as 1.61%.  Since then, it has vaulted as high as 2.72% and most recently closed at 2.63%.  Such a jump in yields is, as kindergartners would put it, ginormous. 

The inverse math of the bond market would dictate that when yields jump this much this fast, the principal value of bonds will fall painfully and nasty losses will be incurred.  While precise numbers aren't readily available, losses in Treasuries may reach a trillion dollars.  And when you add in corporates, munis, junk bonds, and mortgage-backed securities, the losses could be multiple trillions.

The game of musical losses is now in progress.  Through short positions, derivatives contracts and other hedges, the losses are flowing through to wherever they will end up.  The challenge for regulators is to find out, and quickly, where that end will be.  What must be ascertained is whether the losses are spread out and landing in places where they can be absorbed without too much fuss.  Or whether the losses are concentrated somewhere and could have secondary and tertiary rippling effects (i.e., cause a run on one or a few major financial institution(s)).  Well within living memory (2008, to be exact), sharp losses in the mortgage markets triggered tsunamis in the financial markets that washed over Bear Stearns and Lehman Brothers, and threatened to wipe out AIG, Fannie Mae, Freddie Mac and Merrill Lynch.  Bailouts and regulator-encouraged acquisitions barely prevented an abrupt, loud, low-flow flush of the entire financial system.

Regulators should be proactively trying to pin down where the bond market losses will fall.  Complicating their task is the likelihood of speculators who used leverage to make derivatives bets on a fall in interest rates.  Since there is no prohibition on speculating with derivatives, as opposed to hedging, it is possible (and probable) that some players in the financial markets made such a bet.  That wouldn't be intrinsically different from the bet that John Paulson made in mortgages shortly before the mortgage crisis that sweetened his net worth by billions.  It's also not intrinsically different from the gold bets that John Paulson's gold fund has likely made, which reportedly has sustained losses in excess of 60% (ouch).  Any such speculative bets in the bond markets could exacerbate the game of musical losses, and make the regulators' tasks all the more difficult, since many of the speculators might be trading through entities chartered in off-shore locations that might frustrate U.S. government oversight.  But the Feds will have to do their best, because the alternative would be what happened in 2008, when they waited until things blew up and bailouts were just about the only option.

There's more.  The yield curve has been steepening during the last two months.  The short end remains squashed by the Fed's scorched earth policy on short term interest rates.  But the long end, as we noted above, has been rising meteorically.  This steepening makes attractive a type of carry trade.  It's possible to make a lot of money by borrowing short term and investing long term.  

Fed policy makes this carry trade all the more enticing.  The Fed's intent, as far as it can be discerned from the entrails currently visible, is to begin cutting down on bond purchases (i.e., QE) within months, but to keep short term rates at zero until unemployment reaches 6.5%.  Although employment has been rising, the unemployment rate has been static for several months.  While no one really knows when unemployment will reach 6.5%, it's not uncommon to read predictions of mid-2014 or so for that level to be acheived.  If so, the carry trade could be profitable for a while, especially if the Fed's reduction of bond purchases push long term yields even higher. 

To paraphrase P.T. Barnum, or Mark Twain, or somebody, there's a smarty pants who shows up in the financial markets every minute. Some--and perhaps many-- will surely indulge in this carry trade, most likely on a leveraged basis (because leverage boosts profits, assuming the trade works in your favor).  But if the unemployment rate unexpectedly drops quickly to 6.5%, the partakers of this carry trade might wonder if they aren't living in a septic tank. 

Either way, the regulators have to keep an eye out for the possibility of mounting risks from this sort of carry trade.  It could look like easy money to banks, hedge funds, insurance companies and other important players in the financial markets--after all, with the Federal Reserve at least momentarily anchoring their borrowing costs while pushing up their profits, the government is on their side.  But borrowing short to invest long is the E. coli that has poisoned many a would-be financial marvel.  Regulators need to be watchful not only for bond market losses from risks that have already materialized, but also for the growth of more risk from the changing landscape of the market.

Beware of Overpriced Assets

The delirious exuberance of stocks today is reminiscent of the stock market just before its earlier peaks in March and April 2000, and in the fall of 2007.  Prices move up in defiance of risks and uncertainties.  Stock indices set records every week.  Bulls overrun the markets.  Bears have become a seriously endangered species.

Even as financial messiahs proclaim a brave new market in spite of the stumbling economic recovery in America and recession in the rest of the industrialized world, let us recall the sources of the last two market busts:  highly overpriced assets.  In the late 1990s, the bubble was in tech stocks.  In 2007-08, housing and real estate mortgages were grossly overpriced.  In both instances, the sheer quantity of inflated assets ensured that when the markets turned, losses would be enormous.  Given the dazzling rise of stocks over the past few years, it behooves us to ask if there is a comparable risk today?

The answer would appear to be yes.  Investors have poured vast amounts of money into bonds of every stripe and variety.  Bond valuations, even of junk bonds, have reached highly optimistic levels.  Bonds are priced for perfection.  If any imperfection appears, losses--and a lot of them--will follow.

The most obvious risk to bondholders is that the Federal Reserve and other central banks will step back from the extremely accommodative policies they have instituted.  This will happen sooner or later, probably sooner in America and later in Europe and Japan.  When it does, bondholders will incur losses, and those losses will be big simply because of the huge amounts of money that have flowed into bonds. 

The Fed seems to think it can manage the process of shifting from quantitative easing to unwinding its $3 trillion plus balance sheet (i.e., quantitative tightening).  Perhaps it can do so without causing severe short-term turmoil in the markets.  But it can't circumvent a basic problem:  when interest rates rise and bond prices fall, a lot of losses will be incurred.  These losses must land somewhere.  They might be shifted from one investor to another by means of derivatives and other hedges.  But someone, ultimately, has to take the loss. 

The fact that losses in the financial markets have to land on someone somewhere wreaked havoc on the world's major economies following the real estate crash of 2007-08.  Investors around the globe who bought mortgage-backed securities, CDOs, CDOs squared, and other such financial alchemy paid the price for drinking too much of the Kool-Aid du jour.  We live with the resulting economic pain even to this day.

The bond markets are like a coiled spring that presents a similar problem. Extremely high prices have been paid for bonds, and bondholders face serious risk of losses when rates rise.  The sheer quantity of potential losses is the scary thing.  Those losses will have to land on someone, somewhere, and that will be painful.  The Fed's quantitative easing program has only exacerbated the risks, and the Fed's near term success in preventing depression has burnished its image of competence, which may have blinded bond investors to the dangers of the market downturn that must take place eventually.  As history repeatedly has demonstrated, the Fed is fallible and its fallibility is accompanied by serious consequences for the financial markets and the economy.

By promoting ultra low interest rates for five years, the Fed has allowed a massive build-up of investment in overpriced bonds.  While central bank intervention in a crisis is to be applauded, a years-long distortion of market forces will surely do bad things, and bad things have been done.  The only question now is when and how we will suffer the consequences.

How Will the Fed Deal With Speculation on the Fed?

The Federal Reserve's historic announcement today of specific benchmarks for changes in monetary policy--no positive short term interest rates permitted until unemployment is 6.5% or lower, or inflation exceeds 2.5%--got a resounding shrug from the stock market, which closed flat.  Or maybe it wasn't a shrug, but puzzlement.  This policy takes the Fed into uncharted territory, and the truth is no one really knows what will happen next. 

One thing that's certain, though, is financial speculators just got another trading opportunity. With the Fed specifying benchmarks, speculators can concentrate bets on which way economic statistics will go.  For example, if you think unemployment will drop quickly, short sell the long end of the Treasury securities market.  Or buy a derivatives contract over the counter to quietly do the same thing without the regulators having much idea of what you're up to. 

Because of the Fed's unquestioned ability to move the financial markets, these benchmark bets may be very large.  Indeed, as the Fed's balance sheet balloons even more above its current $3 trillion level in its relentless prosecution of QE ad infinitum, its potential impact on the financial markets will billow proportionately.  Speculators may pile on the risk in the hope of getting even more bang for the leveraged buck. 

With prospects for "real" investments like stocks and bonds murky and guarded, hedge funds and other money managers may be tempted to make benchmark bets instead of living with the disappointing returns available from the real world.  After all, they need to beat the averages in order to attract investors, and benchmark betting could offer a lucrative way to do that (if you guess right).  The financial contracts for making such a bet are manifold, so the quantity of betting may be unlimited.  Since much of this betting could take place in the over-the-counter derivatives markets, central banks and other regulators might not have a good idea how much gambling is going on.  The specter of systemic risk could lurk. 

If benchmark betting becomes a popular play, the Fed might be confronted with the problem of collateral damage to the financial system and economy if economic statistics move in unexpected ways.  If important players in the financial markets suffer a lot of collateral damage from speculative wounds, the Fed might have to deviate from its expected course of action (such as by not raising interest rates or working down its balance sheet even though unemployment drops below the 6.5% benchmark).  In such an instance, the very policy that the Fed is attempting to implement could be undermined. 

But there is no practical way for the Fed to prevent benchmark betting.  Even if it can control the risks taken by the largest money center banks (and that's no certainty by a long shot--witness J.P. Morgan's London Whale debacle), it can't control the risks that myriad hedge funds and other investment vehicles, many of which would be in other countries, might take.  If a lot of these speculators are leaning right when the economic statistics move left, the Fed and other central banks might have a highly problematic problem. 

The idea behind the Fed's announcement of benchmarks is to make monetary policy more transparent and understandable.  That's nice theory.  But the abundance of wise guy speculators in the financial markets can muck up (that's the polite phraseology) the works. 

Would You Invest in Government?

Investors have an unusual problem today:  should they invest in government?  No, that's not political rhetoric.  It's perhaps the biggest question facing anyone with cash to allocate.  Asset prices have been manipulated upward by central banks and other government policies.  Stocks and bonds would not be trading at today's prices had it not been for all of the merry money printing by the major central banks during the past few years.  Indeed, the Federal Reserve takes credit for over half the rise in stock prices since 1994.  See http://blogger.uncleleosden.com/2012/07/stocks-are-not-cheap.html.  If you buy stocks or bonds now, you're betting that central banks can continue this juggling act. Is that possible?  Let's look at real estate.

Real estate prices for decades received government support on a massive scale.  Beginning in the 1930s and 1940s, various government lending and finance programs (think Fannie Mae, Freddie Mac, Ginnie Mae, FHA, etc.), along with tax deductions for mortgage interest and property taxes, plus more specialized programs like federal flood insurance, have combined to create a vast support network for real estate, worth trillions of dollars.  Add Federal Reserve easy money policies starting in the 1990s going forward, and real estate prices were boosted leaps and bounds by government largess.  We know, however, how this story ends.  Humpty Dumpty had a great fall, and all the government's programs and bailouts since the financial crisis of 2007-08 haven't put Humpty together again.  To be sure, a great deal of private avarice and stupidity played central roles in the real estate catastrophe.  But the presence of the government, lending a helping hand at every turn, made it easy to believe that real estate prices would never drop. 

Stock and bond prices now seem similarly invincible.  Even though Europe is sliding into recession, China's growth is slowing, and America's economy sputters and coughs just above recession level, stocks keep bubbling up.  Any positive economic statistics add to the ecstasy.  Negative ones slip from short term memory.  Many investors skittish about stocks have no qualms about diving into bonds, even though bond values have been driven to extreme heights.  Central bankers worldwide issue virtual carbon copies of each other's press releases declaring their unswerving commitment to keep printing money until . . . well, until . . . well, it's not clear where the process will end because the printing presses are now set to run ad infinitum.

To invest today, you have to pay the government prescribed price. To assess the risks of financial assets, you have to give heavy weight to political considerations--and those ain't pretty.  Buying financial assets like stocks and bonds is essentially an act of faith--faith in governments, and especially in central banks.  But faithfulness in this respect may not get you through the Pearly Gates.

Maybe the Retail Investor is Retiring

A persistent trend for the past three years is that retail investors have been bailing out of the stock market. Even now, with the market reaching new post-2008 highs, individual investors continue their exodus. Stock market pundits scold shrilly, pointing out that these wusses have missed out on the big rally of the past six months. The same wusses are deemed to be short-sighted for piling into bond funds at a time of historically low interest rates following a 30-year bond market rally. The pundits pronounce retail investors foolish, or worse.

But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.

The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.

An Omen of Financial Stress?

Something strange is happening in the short end of the Treasury securities market. Treasuries maturing in about 1 month are yielding around 0.01%. Just a couple of weeks ago, yields were above 0.10%. Perhaps this may all seem like peanuts (and it is, if you have, say, $10,000 invested). But a yield of 0.01% was last seen during the dark days of the credit crunch in late 2008 and in 2009, when the world's banking system faced a funding crisis. Such a low yield signified that no one trusted anything except the obligations of the U.S. government; that investors didn't care about getting a return. They just want to keep their money safe. The recent 90% plus drop in the short end of the Treasury yield curve in less than two weeks may be a sign that something is rotten somewhere.

Economists and other fortune tellers are raising their estimates for growth next year. Stock prognosticators are full of holiday cheer, predicting rosy returns for stocks in 2011. Consumers may be loosening their purse strings a bit for this year's holiday season. Recent tax legislation will widen the deficit for next year, ensuring that the federal spending spigot won't slow down. All systems are go, it would seem. What's to get stressed about?

Euro Mess. The European response to the Euro bloc sovereign debt crisis, generously assessed, has been tentative and muddled. The only clear impact has been to transfer risk of loss to European taxpayers and give the can a hard kick down the road. The continued uncertainty makes the U.S. greenback look good by comparison (once again demonstrating that it's easy to lose faith in America, until you look at the rest of the world). If you're going to dump Euros for dollars, it makes sense to buy the short end of the Treasury yield curve, where you're not competing against the Fed's quantitative easing program.

One group of potentially nervous investors would be money market funds that hold commercial paper of banks in shaky Euro bloc nations, like Greece and Portugal. Amazingly, in spite of the money market fund credit crunch in 2008, many money market funds bought this foreign issued commercial paper. (One wonders what happened to prudence, but then again prudence is something isn't brought up in polite company.) Those money market funds now may be quietly easing out of Euro bloc bank commercial paper and shifting into Treasuries before year end, when they'd have to disclose their holdings to investors.

Muni Mess. The muni market has fallen, about 5% in the past month. That may not sound like much, but if you held munis and it was your 5%, you'd be peeved. The future for munis isn't pretty. The federally subsidized Build America Bonds program turns into a pumpkin at the end of this year, and there won't be a fairy godmother for it next year. That means states and municipalities will face the harsh winds of the muni market without a quick fix from Uncle Sam. Many financially troubled states are still struggling with their budget problems. To make things worse, questions over states' pension accounting could compel larger state contributions to employee pension funds. Muni investors with battered portfolio syndrome may be seeking a port in the growing storm and heading for the safety of Treasuries.

Bond Mess. The bond market has fallen since early November, when the Fed formally announced its quantitative easing program. Investors who bet that QE would extend the 30 year bull market in bonds may now suspect that this time, things really are different. Those that aren't ready for the quicksands of the stock market may be parking at the short end of the Treasury curve, waiting to see whither the winds blow.

It's unclear that any of this will push the financial system back into the septic tank. Any analysis of that question would require information about who's holding what exposures in the derivatives markets. (Query: are major banks holding the hot tamale because they took the wrong end of the wrong credit default swaps?) But those markets are as opaque as ever, notwithstanding the enactment of the Dodd-Frank financial reform legislation this past summer. All we know is that the short end of the Treasury yield curve is at 0.01%, and the last time that happened, canaries in the mine were gasping.

Will the Bond Market Sandbag the Fed?

Improbably, bonds have rallied for the last 30 years. When Ronald Reagan was elected president in 1980, rates on 30-year Treasuries were in the range of 15%. Today, they pay about 4%. Economists have estimated that real interest rates (i.e., rates net of inflation) run around 3%. Buying a 30-year Treasury today is like gambling on 1% annual inflation for the next thirty years. That's a riskapalooza if there ever was one.

The corporate bond market is also glowingly optimistic about inflation. Recently, McDonald's sold $450 million of 10-year bonds bearing interest of 3.5%. That's like gambling on 0.5% inflation per year for a decade. Then again, if you bought 10-year Treasury notes, which today pay under 3%, you'd be speculating that there will be deflation for 10 years. One would have to go back to the Great Depression to find a time when these investments would have been winners. Reality is we've got a huge bond bubble.

The Fed is desperately seeking inflation. It's keeping interest rates (short, medium and long) ultra low in an effort to stimulate growth, hoping that a little inflation will be like a round of cocktails before dinner that gets the party going. While neither prices nor GDP are cooperating, the Fed persists, in the belief that manipulating the money supply will somehow work a miracle when consumers are scared, corporations are cautious, and Wall Street finances speculations in derivatives rather than production of goods and services.

Here's the catch: if the economy revives, the Fed will have to raise rates. That could pop the bubble in the bond markets, clobbering yet another asset class. If that happened, holders of capital, already pummeled by the 2000 tech stock collapse and the 2008 stock market crash, real estate crash, auction rate securities collapse, etc., would suffer aggravated battered investor syndrome. They'd pull back from risk and consumption. The stagnation the Fed so publicly fears would follow.

But if the Fed doesn't raise interest rates after the economy revives, inflation would flare, ravaging the value of bonds as borrowers repay creditors with cheaper dollars. The bond bubble would pop in this scenario as well, producing severe battered investor syndrome and stagnation.

Thus, the potential for lasting recovery from the Fed's monetary policies may be capped by the bond bubble. There are other reasons why monetary policies may well fail (banks refusing to lend, consumers too scared to spend). But we've got a built-in booby trap set to spring if the economy revives.

The Fed surely knows this, and will probably hold off on raising rates as long as possible. Forget about the widely accepted view that the Fed should raise rates before inflation rears its ugly head to nip the problem in the bud. By incentivizing borrowing as much as possible, short, medium and long term, the Fed faces the possibility of injuring a constituency, creditors, it has tried to protect 100 cents on the dollar since 2008.

The Fed is damned if it does and damned if it doesn't. It has statutory responsibilities to promote full employment and economic growth. But if it succeeds in promoting growth with a little inflation fillip, it will likely pop the bond bubble and produce potentially large investor losses and a renewal of stagnation. Only a slow, agonizing, years-long recovery, with interest rates barely crawling up, would allow creditors to adjust to a rising interest rate environment without sharp losses. But unemployment would have to remain painfully high in such a scenario. Millions of unemployed Americans would pay the price for easing the bond market out of its current dilemma.

The Fed has yet to pop an asset bubble before it became a systemic threat. No doubt, it won't pop the bond bubble now. But it's laying the foundation for painful choices in the future.

Investing in Individual Stocks and Bonds

Back in the days when cars had fins and a household felt lucky to have one television, people invested mostly by buying individual stocks and bonds. The market swung up and down in the 1950's and 1960's, and then really dipped in the 1970's. After that, the benefits of diversification became much more apparent, and investors have gravitated toward mutual funds, and now their latest iteration, ETFs. But what about investing in individual stocks and bonds? Is it a workable way to invest? Is it a good idea? Here are a few thoughts.

1. It'll take a lot of research and analysis. You'll have to look into a number of potential investments before you find a good one. And you'll need a number of good ones to have a reasonably diversified portfolio. Don't invest based solely on someone's recommendation, especially if you got it in a social setting. Would you take financial advice from a financial planner who's had a couple of drinks? If not, why would you take financial advice from an acquaintance or neighbor who's had a couple of drinks? People will boast about their winners, but you won't hear much about their losers. So you'll get only half the story.

2. You'll have the problem of too much choice. There are thousands of mutual funds and ETFs to choose from. There are many, many more individual stocks and bonds. Knowing where to begin your research, and where to stop, will be a challenge. Sure, the Internet provides you a lot of information. But it provides everyone a lot of information. You'll have no informational advantage from using the Internet. You may be thinking that if you had been an early investor in Microsoft or Berkshire Hathaway, you'd be trading up to a bigger yacht today. But which of the many thousands of stocks available today is the next Microsoft or Berkshire Hathaway?

3. You need to keep a lot of records. In order to do your tax returns correctly, you'll have to have a detailed history of the stocks you own. Of course, you need a record of how much you paid for it--and it has to be a good record, like an account statement or a trade confirmation. Your personal notes or your entry in some computer software won't carry a lot of weight with the IRS. And that's just the beginning. You'll need to keep track of stock splits and stock swaps resulting from mergers or corporate recapitalizations. If you participate in a dividend reinvestment program, keeping track of the tax basis in your shares becomes more complex. And if you inherit stock, you need to know the "carry over" basis in the stock (i.e.., its value on the date of death of the person who bequeathed the stock to you). Get used to the idea of keeping some paper records for a very long time, because many computerized records often don't have much legal value as evidence. Further, as computer storage technology changes over time, the data on those floppy disks in the back of your desk will be inaccessible soon, if they aren't already.

4. You still have to diversify, but diversification is much harder with individual stocks and bonds. You need a fair amount of capital to have reasonable diversification, with stockholdings across a number of different industry groups, and in foreign as well as American companies. You'll also need to have some bonds, and the bond part of your portfolio should have a variety of maturities, ranging from at least two to ten years.

5. Unlike mutual fund investments, you'd have to pay commissions to purchase stocks, and also the "bid-ask spread." Stocks are quoted in two prices in the stock market: (a) the "ask" price, at which you buy; and (b) the "bid" price, at which you sell. The difference between these two prices, called the "bid-ask spread" is tantamount to an expense of investing. If you invest for the long term, buying and holding stocks for years or decades, these costs tend to amortize over a long time and become fairly minor. But if you trade stocks a lot, these costs can significantly reduce your returns.

6. You'll face the temptation to trade stocks and bonds on a short term basis, selling whenever you have a bit of a profit. This is a bad idea, because short term trading generally is less profitable than buying and holding. But your stock broker may encourage short term trading because it generates commission income for him or her.

7. At the same time, you have to monitor your portfolio and sell the investments that seem to be going downhill. The value of stocks can sometimes evaporate very quickly. Ask Enron shareholders about this.

8. If you see finance as a hobby or avocation, and are willing to put a lot of time into it, investing in individual stocks and bonds may be enjoyable and profitable. But if all this investing stuff is just work and more work for you, stick with mutual funds and ETFs.

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