Now that Goldman Sachs has forecast that 2010 will be a good year for stocks (and if they expected a lousy year, do you think they'd announce it or just quietly sell?), it's official: All four widely held asset classes -- stocks, bonds, precious metals and real estate -- are expected to continue rising in unison.
The Fed has announced that interest rates will stay near-zero for the foreseeable future, bolstering bonds. Thanks to massive government support of the mortgage market, real estate has "turned the corner." And gold is believed by many analysts to be on its way to $1,350 at a minimum.
That all four asset classes were in parallel bullish trends from 2003 to 2007 was almost unprecedented, and yet this unanimous bullishness is forecast to return in 2010. Three of the four prospered in 2009: Gold has been on a tear, bonds did well, and stocks rose 70% from March lows. Only real estate lagged, but with sales and prices recovering in many markets, residential real estate is expected to rejoin the bullish trend in 2010.
As for commodities, a volatile class few Main Street investors own directly, each can go its own way as global supply and demand, hedging and speculation wax and wane. Though oil, copper, wheat, pork bellies, sugar and coffee rarely move in lockstep for long, the Reuters/Jefferies CRB Index, which tracks commodities, plummeted in 2008 as demand withered during the global financial meltdown. It has since carved out an uptrend that many believe will continue into 2010 as the global recovery gathers steam.
That would make it five for five: all asset classes are expected to move in parallel uptrends.
If something about that uniformity strikes you as questionable, it may be that history and common sense both stand against such parallel trends.
The Normal Ups and Downs of Investing
In general, assets classes operate on a seesaw, not in lockstep, and the reason is commonsensical: When speculative fever is running high, then assets which are rising draw investor funds, fueling further upside, pulling money out of safer, lower-return assets which then dip in price as selling exceeds buying.
Inflation and expectations of inflation have also acted as a seesaw. When inflation rose in the 1970s, stocks and bonds (vulnerable to higher interest rates) fell into a decade-long mudpit, while tangible assets (hedges against future inflation) such as gold and real estate skyrocketed.
(Recall that as interest rates rise, the value of existing bonds drops because their low yields make them unattractive. Interest rates and bond values are also on a seesaw.)
In the go-go 1990s, low interest rates and benign inflation (and benign expectations of inflation) caused stocks and bonds to soar even as gold languished and real estate gains were muted.
In other words, some assets do poorly in inflationary eras and some assets do well in inflationary eras. A situation in which are both types are rising makes no sense. You can't have it both ways.
Betting on (or Against) Higher Inflation, Interest Rates
Investors buying 10-year Treasury bonds paying 3.5% interest are, in effect, betting that interest rates (and inflation) will remain well below 3% for the duration of the bond. Were rates to rise, the coupon value of their bond would plummet. If, for example, the inflation rate rose to, say, 5%, they'd be losing 1.5% on their investment annually. Over time, that small loss would eat a big hole in their principal.
Those piling into stocks are similarly betting that interest rates and inflation will both remain near-zero. Were interest rates to rise substantially, then money would flow to the high returns and relative safety of bonds and out of risky stocks -- which is what happened during the inflationary 1970s.
Those buying gold are betting that inflation or renewed financial turmoil is just around the corner, as precious metals and other tangible assets act as hedges in inflationary times.
Those buying real estate for investment purposes are betting that both will occur: Interest rates will remain low, enabling higher real estate prices, and inflation will rise, pulling real estate values up with it. Deflation or higher rates both act to lower real estate prices.
Why? Real estate valuations and interest rates are also on a seesaw: Higher interest rates boost monthly mortgage payments, placing higher-priced real estate beyond the reach of most households. As demand evaporates, prices fall to what people can afford.
Welcome to the Bubble -- Again
So how can all asset classes be rising together? The answer can be found by examining how they rose in unison in the 2003-2007 housing/oil bubble era, and studying the consequences of super-low interest rates and limitless liquidity.
No surprise: When money is cheap and easy to borrow and interest rates are low, speculation rises and assets skyrocket as speculators pile in, gambling they can earn higher returns than super-low savings or short-term Treasury bond yields.
You've probably seen the chart of U.S. money supply somewhere in the past year: it has exploded upward in a hockey-stick spike as the Federal Reserve and U.S. government have flooded the financial system with liquidity.
That means large speculators and commercial traders at banks and hedge funds have access to cheap money, courtesy of the Fed and Treasury, which they can borrow for next to nothing and plow into assets--any assets, the riskier the better, because there's plenty more money where that came from.
The only way anyone on Main Street can participate in the Federal "nearly free money" giveaway is to buy a house with a tax credit or refinance an existing mortgage -- if they have the income and equity to support it.
The Fed has bought $1.2 trillion in distressed (toxic) mortgages in an attempt to restart the private mortgage market, but so far it hasn't worked. According to BusinessWeek, fully 99% of the $1.5 trillion mortgage securities issued year to date are backed by the government; a mere 1% ($15 billion) have been issued by banks and other private firms.
The Free Money River Can't Flow Forever
Predictably, the flood of "free" tax money has sparked widespread abuse of the tax credit and renewed speculation in real estate.
In effect, the Federal Reserve and agencies of the Federal government such as the Treasury and Federal Housing Administration have flooded the financial system with so much easy money that heavyweight speculators have been encouraged to borrow at near-zero rates and throw the money into whatever asset is "hot" this week or month. Any return above the cost of borrowing is gravy, so why not chase asset prices higher?
The Keynesians among us have been pounding the tables for months, claiming that borrowing trillions of dollars for stimulus and liquidity is necessary to restart the U.S. economy. But precious little of those trillions have flowed into Main Street; while all asset classes have been moving upward in unison, sales and income tax receipts -- the only measure of economic activity which can't be fudged -- continue to fall.
Common sense informs us that the interest on borrowed money has to be paid, even if the money was squandered. The Keynesians claim such costs are minimal, but others look to Japan as a model for what happens when governments pursue a path of limitless liquidity and low interest rates: Over 40% of Japan's national tax revenues go just to pay interest on their skyrocketing "low interest rate" national debt.
What will happen if -- or rather, when -- the Fed and Treasury-provided liquidity dries up? All those assets which have been bubbling higher will fall in unison, just as they rose in unison. Reinflating asset bubbles is not the same as restarting real growth in Main Street U.S.A.
Charles Hugh Smith writes the Of Two Minds blog and is the author of eight books, most recently Survival+: Structuring Prosperity for Yourself and the Nation.
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