by Alexander Green, Chief Investment Strategist
Monday, July 26, 2010: Issue #1309

The brickbats are starting to pour in.

For months, I’ve warned readers about the bubble developing in long-term Treasury bonds.

Yet what was the top-performing asset class in the first half of 2010?

You guessed it: Long-term Treasury bonds, with a total return – price gains plus interest – of 13.2%.

Why is this happening? Two reasons…

• U.S. stocks performed poorly over the first six months of 2010 – down 5.6%. That’s driving many to the perceived safety of Treasuries.
• The anemic euro is making U.S.-dollar-denominated securities attractive to international investors. And Treasuries are the traditional choice for those fearful of equities.

So does this mean there isn’t a bubble after all? Hardly. In fact, the risk now is greater than ever…

1999: An Internet Odyssey

In the fall of 1999, I belonged to a ritzy tennis club – a time when Internet and technology stocks were all the rage.

My playing partners knew I was in the money management business, so there was plenty of chatter among them about “the New Era” and how “the Internet changes everything.”

Occasionally, one of my buddies would ask which Internet stocks I was buying.

“None,” I said. (I was early to get into the sector and early to get out.) The valuations were outrageous and I didn’t think it would end well.

They were surprised by this view, but kept enthusiastically buying and trading Internet stocks like almost everyone else. And, indeed, those stocks kept right on going up.

As the weeks went by, a familiar ritual developed. I’d walk up to the group and – knowing I didn’t own any – they’d ask how my Internet stocks were doing.

Laughs all around.

This went on week after week, month after month. And judging by the guffaws, the question was funnier each week than the week before.

Until one day it wasn’t funny at all.

2000: Nightmare on Wall Street

In March of 2000, the Nasdaq started coming apart and Internet stocks nosedived. As I approached their courtside table one morning, they abruptly stop talking.

“Morning, guys,” I said. “How are your Internet stocks doing?”

Funny… that line was hilarious before. Now it generated obscene gestures, as well as various suggestions for me and “the horse you rode in on.” Hmm.

What is the lesson here (other than that we shouldn’t laugh at the misfortunes of others)?

It’s that you cannot make a rational judgment about when irrational behavior will end.

The “Twin Demons in the Distance” For Treasury Bonds

Internet stocks went up longer than any logical analysis would predict. So did home prices a few years ago.

And the situation with long Treasury bonds right now also defies analysis. Unless, of course, we’re headed into a massive, deflationary period. But if that’s the case, why are gold and inflation-adjusted Treasuries (TIPS) moving up, too?

Either buyers of gold and TIPS are wrong – or buyers of long-term Treasuries are wrong. I think you know where I stand.

As The Wall Street Journal reported on July 6: “The huge stimulus the Federal Reserve and U.S. government have provided to the economy over the past few years will inevitably push up both interest rates and consumer prices. While the threat isn’t imminent, it’s not too early to take steps to protect the bond part of your portfolio from those twin demons in the distance.”

Consider yourself warned.

Good investing,

Alexander Green

by Alexander Green, Chief Investment Strategist

Wednesday, June 9, 2010: Issue #1277

First one friend called. Then another. And then yet another.

Now their friends are calling me, too, asking about my “End-of-the-World Portfolio.”

So I’ve decided to just go ahead and tell everyone about it.

All the friends who called – and their friends, too – are well-educated businessmen. They’re convinced that not only the United States government, but also the governments of Europe, Britain and Japan have simply lost their tether.

We’ve all seen deficit spending before. It’s been a problem for decades. But nothing like this…

Putting the Eye-Popping Numbers into Perspective

The unfunded liabilities for Social Security, Medicare and Medicaid alone now top $108 trillion.

Of course, that number is too large to mean anything to most of us. It’s only when you bring it into context that it becomes alarming.

The $108 trillion is approximately $815,000 per U.S. taxpayer. (And this is just the projected shortfall in Social Security, Medicare and Medicaid. It has nothing to do with the rest of the federal debt, which tops $13 trillion.)

Entitlement spending in other parts of the world is an even bigger problem. And the federal deficits are even more gargantuan. In Japan, for example, debt as a percentage of GDP will hit 200% this year.

Many of my friends look at the fiscal problems in Greece – that necessitated a $1 trillion bailout from the European Union – as just a warning shot across the bow. They’re concerned that things are only just beginning to unravel and will get considerably worse.

Are they right? Only time will tell. But here’s what they keep telling me…

Are You At the Mercy of Wasteful Governments?

“Alex, I busted my hump to earn this money. I’ve paid taxes on it. I’ve saved it instead of spending it. I’m not going down with the ship if those boneheads in Washington spend us into oblivion. How do I protect myself?”

Let me begin by saying that I’ve listened to apocalyptic economic forecasts for decades now. Putting all your money in gold bullion, freeze-dried food and shotgun shells hasn’t been a particularly auspicious strategy.

The difference here is that these folks aren’t gloom-and-doomers who have droned the same message for over 30 years. They are ordinarily optimistic folks who think Western governments are driving the world economy down the road to ruin.

The knock against democracy in Greece and Rome a few thousand years ago was that once the electorate realized they could use their representatives to loot the Treasury, all would be lost. Lately, that remark is looking prescient.

As one friend summed it up: “Look, Alex, I don’t care if I’m wrong about Armageddon and my returns turn out to be lower than what they might have been. Just tell me what to do so I can hang on to what I’ve got and maybe match or beat inflation by a little bit.”

How to Allocate Your Assets in the “End-of-the-World Portfolio”

With that modest goal in mind, here is my suggestion if you want to hunker down for the end of the world – a posture that admittedly may be premature.

• Put 40% of your liquid portfolio in a laddered portfolio of AAA-insured, tax-free bonds. (Be sure to buy state-specific bonds if you’re in a high-tax state.)
• Put 40% in a laddered portfolio of inflation-adjusted Treasuries, also AAA-rated. (For tax reasons, these are best owned in your retirement account.) This is your protection against inflation, as Uncle Sam might opt to spend us out of a tight spot with interest rates already near zero.
• Put the remaining 20% in defensive, blue-chip, dividend-paying stocks. I’m referring to food companies, healthcare companies, utilities, defense contractors, gold mining companies and the like. This should provide some growth and income.

Why include stocks at all? Because 200 years of history shows that an 80/20 split between stocks and bonds is actually less risky than a 100% bond portfolio.

On a personal note, I would not invest my own money this way. (At least not yet.) I’m not calling for the end of the world.

But my friends seem grateful just to have a clear-cut plan. One of them even concedes that it’s not his “End-of-the-World Portfolio”: “I tell people it’s my “Cup-Your-Groin Portfolio.”

I suppose it is. I only hope our elected misrepresentatives get the message before we all need one.

Good investing,

Alexander Green

Laddering means varying your portfolio between short-, medium- and long-term bonds. This is your protection against deflation and the virtual certainty of higher taxes.

by Alexander Green, Chief Investment Strategist
Tuesday, June 1, 2010: Issue #1271

U.S. Treasury bonds are the safest investment in the world.

However, that doesn’t mean they can’t be dangerous. Far from it.

Yet a few days ago, The Wall Street Journal reported that, “Long-dated Treasury securities are now the most favored financial assets for global investors fleeing the eurozone’s debt crisis.”

Talk about jumping out of the frying pan and into the fire…

Don’t get me wrong. I’m not one of those end-of-the-worlders who expect the U.S. government to default on its sovereign obligations. That won’t happen.

It wouldn’t even be necessary. After all, history shows that governments always prefer to inflate their way out of a debt crisis by cranking up the printing presses instead. That way they can achieve a de facto debt reduction simply by devaluing the currency.

If you’ve seen the photographs of German citizens hauling wheelbarrows full of cash into the bank during the days of the Weimar Republic, you know what I’m talking about.

Of course, I don’t expect inflation like that. And neither should you.

But what kind of inflation does an investor expect who loans his money to the government for 30 years at a rate of just 4.1%?

Why U.S. Treasury Bonds Could Bulldoze Your Portfolio

That 4.1% figure is the current yield on the long end – and it’s a bet that has a little upside potential and a whole world of downside risk. Why?

Imagine a seesaw with interest rates and inflation on one end and bond prices on the other. If inflation goes down, bond prices go up. And vice-versa.

But how far down can rates go on the long end? Unless we have the sort of deflationary environment that Japan suffered in the 1990s, the appreciation potential here is minimal.

On the other hand, if inflation rears its ugly head, long bonds will get clobbered. And the worse inflation gets, the worse these bonds will do.

I realize that inflation is not an immediate threat. Technology and deregulation have brought costs down over the past decade. And even oil prices have moderated lately.

But if the bond market gets even a whiff of higher inflation, these bonds will drop like a stone. And I’m betting that investors who weren’t around during the early 1980s – and even many who were – don’t realize it.

They are so busy patting themselves on the back for eliminating default risk – and picking up a 4% yield versus next-to-nothing on the short end – that they are forgetting about interest rate risk: the risk that higher inflation will send long yields soaring and bond prices crashing.

Don’t Let the Government Trick You into Speculating

Seth Klarman, President of the Baupost Group, an investment firm in Boston that manages $22 billion, says the U.S. government is inadvertently provoking its citizens into taking very bad risks right now.

How?

“By holding short-term interest rates near zero, the government is basically tricking the population into going long on just about every security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

Of course, most people aren’t exactly in a speculating mood right now.

So what are they doing? They’re buying super safe long-term Treasuries and earning over 4%.

Except that’s not a safe investment – as many will eventually learn to their chagrin.

Good investing,

Alexander Green

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by Alexander Green, Chief Investment Strategist
Monday, April 19, 2010: Issue #1241

A recent Communiqué column of mine, in which I recommended Treasury Inflation-Protected Securities (TIPS), outraged a number of readers.

Why was it so upsetting? Because – and don’t ask me what they’re smoking – 17% of Americans actually approve of the job Congress is doing.

Taking both parties to task, however, I wrote:

#1: When George W. Bush and his fellow Republicans came to power a little more than nine years ago, they promised to cut wasteful spending, limit the size of government and move closer to a balanced budget.

Instead, they…

• Created a Medicare drug entitlement that will cost nearly $1 trillion in its first decade…
• Started a string of expensive financial bailouts that continues today…
• Passed a record number of earmarks…
• Increased federal spending 58% faster than inflation…
• Presided over a $2.5 trillion increase in the public debt.

#2: Then, last November – anxious for change – voters threw the bums out and put the Democrats in charge. The Democrats promised to change this reckless course and restore fiscal sanity to the country.

Instead, they tripled the budget deficit in their first year. The White House and the Congressional Budget Office now estimate that this year’s deficit will explode to $1.56 trillion – a post-World War II record at 11% of the overall economy – and add $9.7 trillion in debt over the next decade.

Facts vs. Opinions

Here are the other points I made…

#3: The Obama Administration’s own projections see the federal debt hitting $18.5 trillion by 2020. However, that was before the passage of the healthcare reform bill – the biggest new entitlement since the creation of Medicare in 1965.

#4: Unfunded liabilities for Social Security, Medicare, Medicaid, the prescription drug benefit and the new federal healthcare program have now jumped to $108 trillion, nearly eight times our annual GDP.

#5: Moody’s has threatened to downgrade the Triple-A rating of U.S. sovereign debt, perhaps within three years. A drop in our credit rating would both decrease the perceived safety of Treasury securities and increase the interest that Uncle Sam – excuse me, you, your children and your grandchildren – will pay on the deficit.

#6: Credit Suisse recently produced a report pointing out that the country whose debt profile most resembles that of Greece is – hold your breath – the United States. (If you believe a picture is worth a thousand words, try this: http://www.usdebtclock.org/)

#7: Down the road, Washington – with the reluctant consent of the Federal Reserve – could opt to solve this problem the way so many governments throughout history have – by inflating our way out of it.

Inflation: The Bane of Debt-Holders & A Godsend to Debtors

Inflation is the bane of debt-holders, of course. But it is a godsend to debtors – and Uncle Sam is the biggest of them all – as they can repay fixed obligations with increasingly worthless currency.

What surprised me was not that some readers had a difference of opinion. I always welcome that. It was that respondents uniformly barked that they didn’t want to hear my “political opinions.”

Opinions? Go back through these seven points and tell me which one contains an opinion. Even the last one modestly states that Uncle Sam “could opt” to inflate our way out of this problem.

As Jack Nicholson reminded us in A Few Good Men, some people can’t handle the truth. Especially when it’s something they don’t want to hear.

For example…

• When we warned 11 years ago about the massive bubble in Internet stocks, the majority of respondents gushed about the New Era and insisted we “just didn’t get it.”
• When we warned six years ago about the ominous housing bubble, many scoffed and insisted that home prices “always go up.”
• When we talk today about the threat to your financial security that Washington is creating with its Ponzi-style entitlement schemes, a lot of investors don’t want to hear that, either.

Believe me, I hope I’m wrong. I don’t want high inflation any more than you do.

Fortunately, inflation today is as tame as a kitten.

The Benefits of Treasury Inflation-Protected Securities & Three Ways to Buy Them

I only suggest that you buy Treasury Inflation-Protected Securities ( TIPS) as an important insurance policy. (Because when inflation – the thief that robs us all – rears its ugly head, neither stocks nor bonds do well.)

You can purchase inflation-protected Treasuries (TIPS) in three ways…

• Directly ( http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm).
• Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
• Through the ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).

There are several advantages to buying TIPS…

• TIPS pay interest every six months, just like a regular Treasury bond. But unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation.
• The interest you receive is exempt from state and local (but not federal) income taxes.
• TIPS are less volatile than traditional bonds.
• They’re also excellent diversifiers.

Some investors complain that these securities haven’t done anything exciting lately. Of course not. We’ve been in the grip of disinflationary forces, not inflationary ones – and that won’t change next week or next month.

Protection Against The Government “Doing Something”

But as the deficit keeps expanding and the electorate grows increasingly unhappy, pressure will mount on the government to “do something.”

That “something” could be a decision to inflate our way out of this mess, rather than risk the kind of deflationary spiral that Japan has endured over the past two decades.

Bear in mind…

• The Fed has already taken interest rates close to zero…
• Congress has already tried a massive fiscal stimulus…
• The Federal Reserve has already created trillions out of thin air to mop up worthless securities.

If the economy stumbles again and further government action is taken, it could be even more reckless, resulting in inflation.

In the interest of full disclosure, however, that’s just my opinion.

Good investing,

Alexander Green

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