Global Overview

There are now a number of sources and commentators on the Internet who are discussing and explaining such matters as why the current market stability may be a matter of appearances only, and the nature of the deflationary process. These things have become somewhat hot topics! I give an external link below to a useful site that provides regularly updated links to a lot of the most current articles. And Myers' book, mentioned above, is worth reading. It seems to have been largely forgotten but offers a clear cant-free explanation of inflation, fiat money, the gold standard and the underlying causes of deflation. Myers well understood the non-linear nature of the process of credit collapse which he likened to a chemical precipitation. Understand it, and think it through to its practical consequences, and you will have a pretty good grasp of the basics.

The fact that the series of financial and economic shocks that have been experienced around the world were not followed within a few weeks or months by a significant downturn in the US is not evidence of anything. It is surprising to me, given the historical record which is open to anyone to read, how, simply because some event such as the Russian debt default has not led immediately to a collapse of the US stockmarkets, it is assumed therefore that nothing serious is now going to happen.

We are in a long secular bond bull market that began in 1981, and which looks set to continue. This is not unprecedented: there was another great bond bull market in America which began in 1920 and lasted right through the Roaring Twenties, the Great Depression, and the Second World War. It did not end until 1946. (Keep that in mind when you read any analyst who says that our falling interest rates must be good for equities: interest rates indeed were trending down as stocks soared through the 1920s: but they continued to fall as stocks plummeted in the 1930s [and they still continued down as stocks began to recover in the early 1940s]). There were two significant, but short-lived, reversals in this long trend, both directly associated with the Fed raising interest rates. The first was in 1929, when the discount rate was raised as high as 6% in a by then ineffective attempt to slow the out-of-control stock market bubble. The second occasion was in late 1931-early 1932 when Fed rates, which had been substantially reduced in the intervening period, were again jacked up, this time in response to the growing outflow of gold bullion from the US. Both episodes proved to be good buying opportunities both for government bonds and for prime corporate bonds (see below).

We are used to interest rates and being linked to inflation expectations, and because of that there remains some tendency to see any spike in bond yields as evidence of an inflation threat. But, in the current environment, interest rates and bond yields are now dependent more on different considerations. The setting of key rates by many Central Banks is no longer driven by the desire to stamp out inflation, but by the need to bolster a weak currency (e.g. The Canadian CB increased the bank rate by a full 1% a few weeks ago because the dollar was collapsing), or in an effort to prevent or reverse economic problems (e.g. recent US Fed action). Bond yields will respond to CB moves, but not necessarily in the same direction (e.g. a too vigorous easing by a CB may trigger inflation fears which would drive bond yields up). Bond yields are an additive of both inflation expectations and of a risk premium: the former has mostly been decreasing but the latter has been increasing and is now the major factor that the bond investor must gauge. The risk is not only the possibility of default by the borrower, but also, increasingly, currency and interest rate volatility.

YEAR .......... AVERAGE YIELD

1932 .......... 4.61%
1933 .......... 4.19%
1934 .......... 3.83%
1935 .......... 3.44%

1940 .......... 2.70%

1945 .......... 2.54%
1946 .......... 2.45%

They bottomed in April 1946 (2.37%).

Clearly many holders of the highest quality corporate bonds were satisfactorily rewarded during the Depression years.

On December 29, 1989, the Nikkei stock average peaked at 38,916. On Friday (November 20, 1998) it closed at 14,780. In other words, after nine long years, Japanese stocks are still down 62 percent from their high. In fact, on average, anyone who purchased Japanese stocks at any time from 1985 on and held on to them is still waiting to break even. Who will still believe in buy-and-hold if by July 2007, the DJIA has fallen to 3540 ?

Adam Smith in "The Money Game" tells the following story that illustrates the potential perils of investing for the long term. A certain Timothy Bancroft come through the Panic of 1857 unscathed by holding on to his investments and not selling. This experience convinced him that the only way to invest was, in his words, to "buy good securities, put them away and forget them." He carefully selected and accumulated stock in good companies dealing in essential goods and services. When he died his estate was valued at $1,355,250. But unfortunately for his heirs, by the time the estate was settled the shares of Southern Zinc, Gold Belt Mining, Carrel Company of New Hampshire, and American Alarm Clock Company, [all the bluest of blue chips in their time], and his entire estate, were worthless.

Take care!