[With unemployment above 9% and productive capacity heavily underutilized, the U.S. economy is slipping back into official recession. In a letter to clients, our friend and financial advisor Doug Behnfield has predicted that deflation is about to return with a vengeance -- presumably with bullish implications for high-quality bonds and, get this… municipal bonds. For Doug’s take on the stock market, fixed-income securities and a Baby Boomer cohort that is ill-prepared financially for retirement, read on. RA]

Over the last few weeks, stock, bond and commodity markets appear to have played “catch up” to fundamental economic changes that began early in the first quarter. In early February, 30-Year Treasury Bond yields peaked at 4.8% and started down sharply as bond prices rose. The municipal bond market did the same. The S&P 500 hit 1300 and essentially stopped rising, creating a volatile topping process that lasted until late July. Since then, the bottom has been dropping out of both stock prices and bond yields. The Fed has promised to keep very short term interest rates at 0% for at least the next two years.

The economy now appears to have rolled over early in the year. Employment and housing prices peaked in the first quarter and GDP growth was revised down to 0.4%. At year end 2010, Q1 2011 GDP growth was widely expected to exceed 3.5%. State and local governments began aggressively tightening their budgets and it seems clear that the federal government will be doing the same. Standard & Poor’s (and the other rating agencies to a lesser degree) have put congress and the administration on notice that the debt bomb must be defused immediately and the vast majority of voters seem to agree. The fiscal drag could be enormous. Or we become a Banana Republic. The median age of the Baby Boomer is now 56, and as a result of extremely poor saving patterns and an ill-timed rush into leveraged real estate investment, they are likely to radically change their approach toward budgeting now that they are in the home stretch to retirement.

It is difficult to imagine that another rabbit can be pulled from the hat. Considering that household credit contraction has been joined by government credit contraction as a secular theme, the most likely economic outlook includes deflation, and it could be severe for asset prices. For the stock market in particular, the near term risks still seem great. The S&P 500 sports a mere 2.3% dividend yield. Bear markets have historically ended with yields above 5% (chart attached). Over 70% of the daily trading volume on the New York Stock Exchange emanates from air conditioned warehouses in New Jersey with no humans in them, just computers running algorithms (what ever they are). On the other hand, deflationary trends are generally favorable for high quality bonds.

No ‘Escape Velocity’ Now

It seems to me that the trend in stock and bond prices that we have experienced over the last several weeks in particular, are likely to persist for the near term. I have not forgotten that I held a similar belief last summer, only to see a dramatic reversal as the Fed convinced the investing public that they had the tools to engineer “escape velocity” for the economy. But QEII failed to deliver any more than temporary rhetorical monetary stimulus and back then, federal fiscal stimulus was still in full force. Now we are faced with fiscal drag at all levels of government and a growing threat from foreign economic events. It is increasingly likely that we have already entered a recession, but this time we are starting with 9% unemployment and very low capacity utilization.

The stock market was down as much as 17% from early May’s highs, but even after the strong bounce in recent days it is still down by 10%. Garden variety bear markets typically produce declines of 25% to 35%.  Recently, the 10-Year Treasury Bond yield touched 2.03%, undercutting the December 2008 modern-era low. Back in December 2008, when the previous low occurred, the 30-Year Treasury Bond yield hit 2.51%. Today it is 3.51% and it seems that yields on the long end have some catching up to do. During the 2008 financial crisis, municipal bonds performed poorly, unlike Treasury bonds, which were the best performing asset (including gold). But in 2007- 2008, several factors occurred that had a negative impact on municipal bond that cannot be repeated. One event was the failure of the auction rate securities market and the other was the failure of the municipal bond insurers. Neither exists today. It is my belief that, this time around, municipal bond performance will be similar to Treasurys.

In conclusion, I am comfortable with my current asset allocation recommendations for the present time, even with the degree of positive relative performance we have achieved so far this year. In addition, I would be delighted if you would share this email with friends, family or associates who could benefit from a more defensive, fixed income view toward financial planning.

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Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indication of future results, so let the buyer beware. There is a substantial risk of loss in futures and option trading, and even experts can, and sometimes do, lose their proverbial shirts.  Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers’ initials will be used unless express written permission has been granted to the contrary. All Contents © 2011, Rick Ackerman. All Rights Reserved. www.rickackerman.com 

-- Posted Wednesday, 17 August 2011 | Digg This Article