Warning The Great Credit Expansion Financial Market Trend of 2009 Is About to End


Stock-Markets / Global Debt Crisis
Dec 14, 2009 – 01:46 PM

By: Q1_Publishing

Renowned speculator Bernard Baruch once said, “The main purpose of the stock market is to make fools of as many men as possible.”

As 2009 comes to a close, this year’s most popular investment is likely to make a lot of investors look like fools.

But investors getting prepared now will be able to avoid the hazard and position themselves for maximum profit. Here’s how.

Investors Pile in at Record Rate

Last year’s collapse spooked a lot of investors. After years of piling billions into stock-focused mutual funds, the herd relearned that all investment classes are risky.

The natural response for most investors was to flee to safety. That’s why the most popular investment in 2009 was not volatile commodities and stocks, although their returns make them look like they were. The asset that attracted the most money was actually bonds.
In their hasty flight to safety, investors piled almost $400 billion into bond funds according to financial research firm Strategic Insight.

That’s the biggest bond buying spree in history. Prior to 2009, total bond fund inflows never exceeded $300 billion in a single year.
Avi Nachmeny, Strategic Insight’s director of research sums it pretty well. He says, “With $10 trillion held in cash throughout banks and retail money market funds earning near zero yields, mutual fund shareholders have been slowly recovering from the traumas of 2008 by moving off the sidelines and into the higher yields of bond funds.”

But as history has shown us time and time again, most investors are usually wrong. The newfound love affair with “safe” bonds shouldn’t be any different.

Fooling Everyone Twice

Years of credit growth from government, consumer, and corporate borrowing proved to be unsustainable. Each year more and more credit was piled onto already high debt loads. Companies rolled over trillions in debt. Real estate buyers could easily tap a seemingly unlimited well of credit. The credit bonanza just wouldn’t stop.
It seemed great…until it ended.

Here’s the thing though. The credit crunch should have been a learning experience. But the way this year has shaped up, most investors are about to make the same mistakes all over again.

Only this time, they’re going to do it in an even bigger way.

At the height of the credit expansion, corporate debt issuance hit an all-time record of $960 billion.

This year, however, investors’ flight to the perceived safety of bonds has opened the corporate debt floodgates. According to Bank of America, there corporations are on pace to finance more than $1 trillion worth of debt.

Meanwhile, the U.S. government is looking at adding another $1.4 trillion in debt from next year’s deficits. Also, more than $2 trillion in short-term debt needs to be rolled over.

Then there are state and local governments too. They’re going to have to raise hundreds of billions of dollars to cover budget deficits.
It’s not looking good for debt markets. Massive supply is coming and there will come a point (likely very soon) when the demand just isn’t there and investors will demand higher interest rates.

Despite it all though, most investors are still buying bonds hands over fist.

The world’s best investors, however, are doing the exact opposite.

In Good Company

We’re not the only ones seeing more risk than reward in bonds. Some of the world’s best investors are still getting prepared for inflation, which pushes yields up and bond prices down.

For example, John Paulson, architect of the “Trade of the Century,” didn’t hold anything back in a recent speech. Paulson simply said, “We are concerned about high rates of inflation in the future.”

Aside from his well-documented bets on gold and gold mining stocks, Paulson continues to make moves that would benefit greatly from inflation. His large holding in Bank of America (NYSE:BAC) is a clear indication he believes the debts bogging down bank balance sheets will be inflated away.

Also, the man who literally wrote the book on contrarian investing, David Dreman, continues his drumbeat on inflation. In a recent interview, Dreman said, “The Treasury has been printing money 24/7 and it’s been going on worldwide. That’s going to have its toll. Not now, but two, three, or four years out we’re going to see inflation probably as bad as the 1977 through 81 period when it was 12% annually.”

Finally, Warren Buffett, the world’s greatest investor signaled he’s putting his money – a lot of money – where his mouth is. Berkshire Hathaway’s takeover bid for Burlington Northern Sante Fe (NYSE:BNI) is clear bet on inflation.

You see, Burlington’s real value is in its assets. The railroad owns 23,000 route miles of rail lines. It also owns the trackage rights to an additional 9,000 route miles. Then once the miles of trackage for additional main-lines, shipping yards, and sidings are added in, the total is more than 50,000 miles of track.

It costs $1.3 million to lay a new mile of rail. So we can estimate the value of Burlington’s trackage to be worth about $65 billion.
That’s just for the rails though. Once you add in all the stations, rail cars, locomotives, and the land under the tracks, you’d have to add billions more. Inflation will only push the value of all these assets higher in dollar terms.

That’s why the takeover, which values Burlington at $34 billion, is a good one for now. It’s a great one once inflation is factored in.

Now, the one thing we have to realize is that Paulson, Dreman, and Buffett are not short-term traders. Their success has come from looking beyond the Wall Street’s typical two-month time horizon and the short-term volatility created by the unending inflation/deflation debate. And our success will come from that too.

Bond Market Limbo – How Low Can You Go?

Basically, there are a lot of things to be fearful of when it comes to bonds.

First, there is concern of the record inflow into bond funds.

Second, the inflationary time-bomb that is being built by artificially low interest rates and unprecedented expansion of the monetary base has the potential to wreck bond prices.

Finally, and most importantly, the risk/reward profile doesn’t make any sense for bonds right now. Long-term U.S. Treasury bonds are paying historically low yields. The 30-year T-bond yields a mere 4.50%. Corporate bonds, as tracked by Merrill Lynch’s Corporate and High Yield Master Index, yield 5.64%. That’s down nearly 10% from earlier this year and the lowest point in more than four years.

With yields like that, you have to wonder how much lower can they really go.

The short answer is, not much.

The Best Move to Make Now

This is all why in Prudent Investing, our most popular premium advisory service, we’ve taken steps over the last few months to get in position to earn outsized returns while waiting for inflation to start to hit.

We’ve identified safe, high-yield assets that will sidestep the inevitable inflation. These include buying utilities (which, as identified earlier this week, are cheap and offering attractive yields), picking investments that go up with interest rates, and buying real assets on dips.

In the end though, this is a really simple situation. Bonds prices are high and yields are low. The risks are greater and the rewards are smaller. But that hasn’t stopped the herd from piling in.

We know most investors are usually wrong. It’s a safe bet to assume the bull market in bonds will be no different.

Good investing,

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