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The Markets in 2013: Bonds Stink and Other Critical Observations

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Making sense of the 2013 investment climate means considering trouble in the bond markets, social unrest, and geopolitical turmoil.

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Despite the official statistics, there is a strong underlying inflationary spiral -- look at the prices of meat, milk, and medicine. And in the face of escalating prices, our central bank pursues accommodative measures that, in normal days, would be significantly inflationary. The US equity market has responded to the stimulus with an upward push. And yet, we have also seen the casino effect of overwhelming liquidity chasing too few investment prospects -- it dampens retail investor confidence. Hesitant retail investors and increased retirement demographics have spurred equity outflows and fixed income inflows. For long-term investors like retirees, this is the worst time to move into bonds.

CAUTION: You should only buy bonds for the following reasons:
  • To match a future liability (e.g., college, wedding, etc.)
  • To provide coupon income (hold until maturity, preferably inflation indexed)
If you are buying bonds or bond funds in the hope of taking advantage of continued declines in interest rates, or because the fund performance over the past two years has been good, then stop! Sell any bond funds now, today. Deflation is not going to happen, Mr. Bernanke has dropped the helicopter full of money! The next few years will entail struggles with inflation and higher interest rates, and perhaps a falling US dollar.

The Bernanke Covered Call

The Bernanke put has been replaced with a covered call, and that means our upside is limited and downside is wide open.

Equity markets enjoyed a good year in 2012 despite four years of economic stagnation. On the surface, it seems like the equity markets are poised to continue to grow. However, the impact of the Federal Reserve's covered call on unemployment needs to be understood.

In recent missives, the Fed stated that accommodative measures will be removed when unemployment reaches a target level. Their intent in stating this policy was to inject confidence and stimulate the equity market. As if on cue, the equity markets rose in value at the selling of Bernanke's "call option" -- that was our premium. However, as in all covered-call option trades, the upside is capped. How? The closer that we come to the stated objective, the more that the equity markets will hit choppy waters for fear that stimulus will be removed. This turbulence is the cost of living on artificial stimulus for so many years.

It is a good strategy to trade volatility in 2013. Oversized directional bets are not in the cards until stimulus measures are eased. Play within predefined ranges if you feel compelled to be long equities -- e.g., buy dips and sell highs within your risk tolerance. But, don't put your head in the sand. This is not a "set it and forget it" market for asset allocation.
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