The Bond Bubble has Already Burst - November 2010 Update

The Bond Bubble has already Burst

Crowell Weedon & Co.

Your Independent Investment Team

Established: 1932

Members SIPC / FINRA

Dear Fellow Investors,

It is easy to look back and say what has impacted investors’ results. We could rehash the Derivatives, excess leverage of financial balance sheets, lax oversight of the mortgage industry, healthcare legislation, unemployment and so many other issues over the past few years that have affected the markets. And we could remind you of our beliefs that positive cash flow, dividends, interest, diversification, and compounding are some of the biggest reasons that we have faired better than the markets. But in this letter we want to look forward and not backwards and talk to two specific issues: Money Supply and legislative gridlock.

Much has been made of the seemingly ever-expanding balance sheet of the Federal Reserve. And then added to that all of the borrowings done by the treasury over the past few years to fund an alphabet soup of different bailout programs (TARP, PDCF, MMIFF, CPFF, TSLF, FHFA, AIG). Together our government’s aggregate borrowings have gone from less than a Trillion dollars in 2007 to almost 6 Trillion dollars today. Alarm bells have been ringing in the press that this is inflationary and unsustainable. But the expansion of the government’s balance sheet was done on purpose to save this country from a 1930’s style deflationary depression. The press seems to think that the debt bubble is getting ready to burst. They are wrong - it has already burst. In the 2007 to 2008 time frame the debt load of fiat money that was created by derivatives and synthetic securities had driven the growth of the total amount of money in existence to an unprecedented size. Then, first Bear Sterns imploded and then Lehman Brothers followed almost a year later and the ultra high leverage began to be reigned in. As it was, liquidity dried up and money supply began to shrink at an alarming rate. The bubble had burst. The Treasury and the Federal Reserve stepped into the mess and expanded their balance sheet as rapidly as they could to counterbalance the destruction of money supply. Money supply has stayed close to level for two years now and I for one think we should applaud their efforts. I find it interesting that the financial press wants us to believe that the stimulus has not worked because unemployment is still at such high levels. It was just one of the pieces to the puzzle of counterbalancing the shrinking private sector balance sheets. I shudder to think what the unemployment levels in this country would have been if the Treasury and the Federal Reserve had not acted as quickly and strongly as they did.

I write the above to try to assuage some of the fears of a second leg down in the “Great Recession of 2008 and 2009”. At the same time, we need to recognize that the work has only begun to get the economy back in order. And there are some huge challenges ahead. Not least of which is the Federal Reserve’s liquidity balancing act as non-financial corporations start to deploy some of the significant cash reserves they have been building. In addition, it will take time for the mortgage markets to clear out the foreclosures and repossessions in the system. It will take time for business to become confident enough to invest in plants and equipment that lead to jobs – unemployment could remain high for longer than many would like. And due to the aging of the “Baby Boom” generation, we have some very significant issues that must be addressed legislatively – Healthcare, Medicare and Social Security.

I am writing this letter a day prior to the mid term elections. Right now it appears that the Republicans will regain control of the House of Representatives. In doing so we will once again have branches of the government controlled by two different parties. There is the potential for compromise and constructively dealing with some of the issues that confront the country (similar to 1994 when Clinton was president and the Republicans were lead by Newt Gingrich). But, the tone and rhetoric sounds more divisive and leaning towards gridlock. Gridlock does not mean nothing will happen. The Bush tax cuts will expire, raising taxes. The Health Care legislation will take effect, raising costs to business. Estate taxes will roll back to earlier levels putting the transference of family businesses in greater jeopardy. And the “Baby Boomers” will get older and accrue greater and greater entitlements that will not have funding. Many say that gridlock will be a good thing, as it will curtail a perceived sprint toward socialism, and the reaction from the capitalists will be to rejoice and move the markets higher. If so, I believe that will be a short term reaction until the realities of the underlying economy and the magnitude of energy, time and resources that will be needed to recover from the bursting of the private debt bubble are realized. I remain hopeful that the executive branch will find a way to be more constructive and compromising on the solutions that are needed and work with the legislative branch for the good of the future of our country.

We welcome your comments and look forward to our conversations.

As always we encourage you to seek the counsel of investment professionals who can guide you in your investment decisions and what is appropriate for your individual situation.

Blake Todd

Portfolio Manager

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