Bursting Bubbles by Robert B. Gordon 08/07/2003

FSO Editorials

Bursting Bubbles
Stocks: 2000, Bonds: 2003, Housing: 200?
by Robert B. Gordon, Sc. D.
August 7, 2003

Most young investors have had their entire market experience in a period of falling interest rates, but the credit environment may now be changing. During the stealth bear market in stocks during the 1970s, interest rates were extraordinarily high, in double digits. Rates started down in the early 1980s and have been dropping almost continuously until just 7 weeks ago.

Since June 13, while stocks have continued in the news, a rather startling fall in bond prices has been taking place. For example, on my FastTrack computer screen, during the last six week period, prices of long-term U.S. Treasury bonds have really tumbled. This abrupt drop could be of concern for investors who own bond funds rather than individual bonds. Bond funds hold a large mix of individual bonds so there is never a single maturity date. Fortunately, it is possible to hedge against losses in bond funds with a reverse index short fund.

Corrective action for large institutions such as pension funds, insurance companies etc. may not be an easy matter and they may suffer further losses in their bond principal as well in their stocks. Higher bond prices will also hurt the financial condition of state and local governments that are already in deep trouble.

The gravity of this situation, if it continues, is shown by the following data for the past 7 weeks from June 13 to August 5:

Mutual Fund	7-Week Change %	Annualized Change %
Treasury Money Market Fund	0.14	0.98
Short-Term Treasury Bond Fund	-1.5	-10.3
Intermediate Treasury Bond Fund	-5.4	-32.2
Long-Term Treasury Bond Fund	-12.4	-60.3
Inverse Long Bond Short Fund	18.5	228.0

From the above data it is seen that an equal weight of the Long Bond and its Inverse Short Fund would have been profitable over this time period.

TIMING OF THE THREE BUBBLES

At the recent stock market highs, we know that the percentage of bullish advisors and investors was at the same very high level as it was at the early 2000 market high. This tells me and other bear market observers that stocks still have most of their bear market ahead of them - not behind them as Wall Street bulls would like us to believe. Only time will tell what course the bond market will take as its bear market develops. But after a very long bull market, it would seem that it might, like stocks, be starting on a protracted bear market.

Of course the housing bubble is still growing at this time. It remains to be seen how long it will be until higher mortgage rates have their anticipated effect on both new sales and resale of private housing. If the stock market goes into another severe down leg during the balance of this year, it could have the effect of reducing public confidence in the new and used home market.

REVIEW YOUR PORTFOLIOS NOW

We have been writing about the need for bear market portfolios to use carefully chosen asset classes with a conservative base of short to moderate Treasury bonds and a matching amount of Foreign Government bonds (to neutralize currency effects), owned directly or as mutual funds. Then, we like to see a smaller, diversified group of natural resource and precious metals stocks or funds. Finally, nearly everyone needs to provide a hedge for equity and/or bond positions by owning an appropriate amount of reverse index or fully managed short fund.

We have written quite a few times about the merits of regularly scheduled portfolio rebalancing to maintain the original desired percentages. This is especially advantageous when using volatile asset classes like precious metals and short funds. Profits in these classes are returned to and preserved in the stable classes.

CONSERVATIVE RANGES IN MUTUAL FUND PORTFOLIOS

Short-Term Treasury Bonds	20-30%
Short-Term Foreign Government Bonds	20-30%
Natural Resources	10-15%
Precious Metals	10-15%
Short S & P 500 Index	10-15%
Short Long Bond Index	10-15%

This simple portfolio contains 6 very different asset classes, all of which "march to different drummers." It is specifically planned for periodic rebalancing which if done regularly will transfer profits from volatile classes to stable classes. It is intended for serious investors who will do the periodic rebalancing as needed.

WE AIN'T SEEN 'NUTHIN YET

I urge all readers, old and new, to go to my archive at FSO and read the editorial published on January 26 of this year with the same as this paragraph. I have been expecting this great bear market since 1995 and never anticipated its snail-like speed. However, at this date I am beginning to understand. The unwinding of the great stock bubble is going to take at least as long as the bull market mania that preceded it.

In accordance with the length of time required for the crash will be the magnitude of its effects. I now believe that almost no one foresees the depth to which our stock market and economy will ultimately go. I am almost certain not to be alive when this historic episode is finally completed. I urge all of my readers to be a part of the very small aware minority and take every precaution so that they and their families will survive whatever comes.

Robert B. Gordon, Sc. D.
Sun City West, Arizona
August 7, 2003
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