If you count the bubble in commodities and derivatives, you can count four bubbles in a very short time frame. While not a widely known fact, bubbles tend to burst when short-term rates reach 6% or so. Below you will see a static yield curve for Japanese Treasury yields on January 1, 1990, just around the time that the bubble in Japanese real estate and stocks broke.

In the graph that follows is a time line of the Federal Funds Target Rate that peaked in early 2000 a very similar 6 ½%. Similar rates were seen prior to the breaking of the bubble in 1929 that led to the Great Depression. While rates only moved to 5 ¼% in 2005-2006, it was still enough to break the real estate bubble, presumably because so much debt had been piled up on consumers, particularly in Adjustable Rate Mortgages, the ones that were recommended by then Fed Chairman Alan Greenspan. This was at a time when long-term mortgage rates were at or near record lows.

Japanese Government Yield Curve January 1, 1990

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Federal Funds Target Rate Bubble Time Line

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Summary: What Lies Ahead

There have been many comparisons to the Japanese real estate bubble of the late 1980’s and its ultimate collapse. I featured the chart at the end of the piece in 2005 when I thought that home prices would fall and that the loans and derivatives of those loans (Level 2 and 3 assets among other esoteric investments) would have trouble, possibly for longer than anyone believes. I feel even more strongly that the ultimate fallout will be worse than I initially imagined. The last real estate debacle/credit mess took place in 1989-1990 and it took nearly 15 years for people to be emboldened enough to speculate in real estate again. Note that the Japanese experience took about 15 years to unwind as well. If cycles hold true as they usually do, real estate will have its next peak at least 12 to 15 years from now. I know this sounds draconian, but the level of debt this time around is so extraordinary (it is different this time, but in a negative way) that the unwind will be extraordinary as well.

Japanese Real Estate Cycle

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If the monetary and fiscal spigots are turned off or retarded in 2009 as I suspect they will be, that will be where things get really dicey, a topic I intend to touch on next week in Part Two.

For the balance of the year, usually a good one in the fourth year of a term, I expect more Fed intervention. The intervention may come in the way of new financing tools like its Term Auction Facilities (TAF) for who I feel are its buddies on Wall Street rather than lowering the Federal Funds Rate much more from the current 2%. Some will applaud the Fed's actions as being forward-thinking and with great imagination but frankly, its actions, whether covert or in the public forum (the ‘timing’ of some of the ‘surprise tactics’ is highly suspicious to me and others), they nauseate me.

When we take risk and are wrong, we pay the price. I don’t get to simply ship off my bad trades and pay myself a bonus. Many individuals in our profession are tiring of the special club, what I call the Moral Hazard Club, that has been created for a select few. I suspect as we head towards 2009, there could be backlash against the broker/dealer community and the Federal Reserve.

As for the rest of 2008, I expect a correction in equities, perhaps imminently, followed by a choppy, volatile balance of the year dominated by headlines and election year worries. One thing is for sure, though. The capital raise at financial institutions will continue unabated until enough securities have been force-fed to domestic and international investors alike. This should keep pressure on all markets.

While my firm profited in the first quarter in the Harbor Pilot Fund by maintaining a short credit risk position (a position it covered into the Bear Stearns bailout news), my firm will avoid credit risk for the foreseeable risk and will likely look to selectively short credit risk as we head into late 2008.

2007-2008 may have been a warm up for the Fat Lady to sing in 2009-2010. I continue to believe absolute return investing will remain the key and "managing to a benchmark" may become a dirty phrase. 

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