June ’05    Bonds - The Treasury market is thriving on what can be considered “artificial” demand, in that buyers are not deterred by unattractive yields; they are protecting their currencies, licking their wounds from hedge fund losses, putting on one leg of a complicated derivative strategy, or for some other reason completely divorced from that of an attractive investment return.  This basic consideration is being neglected, but in the end will again come to the fore. The 3%-4.5% trading range on the 10-year note predicted over the next five years by Bill Gross, if it occurs, will doom investors to a period of negative returns and continue the excruciating pressure on corporate pension funds.  Looking at all the stresses in the economy – housing bubble, trade deficit, fiscal deficit, record personal bankruptcies, to name only a few – it would be surprising if this nightmare scenario plays out.  High interest rates will be a blessing, not a curse.

 

                Equities - The possibility that returns from the equity market are apt to remain subdued for the balance of this decade should be taken into account.  The historical pattern of the DJI index is for many years of range bound trading after a period of strong advance, and the range can be disconcertingly wide.  From Depression lows, the index reached 195 in 1937, only to fall 52% to 93 over the next five years.  The 1937 high was not exceeded until 1950, 13 years later, at a level of 206.  For the next 16 years the index advanced at an annual rate of 10.4%, topping out at 1,000 in 1966.  This level was not seen again until 1982, again a period of 16 years.  In the interim, the 1975 low was 570 (‑43%).  After 1982 it was off to the races, the index rising from 1,060 to 11,750 in 2000, a 12.4% annual rate. We are now five years into a trading range where the low has been 7200 (‑38%).  This low might qualify in terms of amplitude, but the time duration doesn’t match.  It seems much too soon to envisage a return to double digit equity gains.  And, for what it’s worth, recent violation of previous lows by both the Dow Transportation and Industrial indices signals a primary bear market, a development which we feel should be given more recognition than it has received.  Although it may not occur, another severe decline in the equity markets during the next 5-7 years cannot be ruled out and is indeed favored by historical precedent.  Forewarned is forearmed.

 

William Wright