The losses are inevitable, and to some extent even quantifiable. The real question is who will actually bear those losses and when. The official policy is clearly for the public to do so, massively, preferably quietly, and over a very long period of time. Still, my impression is that fresh economic weakness could prove to be a tipping point, and that both investors and the public should understand that they are likely to pay terribly for the current abundance of apparently free lunches.
Market Climate
As of last week, the Market Climate for stocks was mixed - valuations remain unfavorable, technical action was mixed but tenuous, with various indices flirting with widely observed levels of support and resistance (e.g. the 1100 level on the S&P 500), while leading measures of economic activity remain decidedly unfavorable. As I noted last week, the average historical outcome of similar combinations has been negative, largely because the deterioration in economic pressures tends to trump technical action even when it has been more favorable than it is at present. Still, there is a clear speculative element in day-to-day market action here, as trend-following investors remain heavily focused on very specific price levels, which can trigger short-term bursts of buying and selling pressure.
Overall, my impression is that the near-term dynamics of the market are likely to be dominated by this sort of speculative trend following activity - primarily because it will probably still take another 4-8 weeks until sensitive coincident economic measures (such as ISM figures and new claims for unemployment) begin to predictably reflect the deterioration we've seen in various composites of leading indicators. Again, if we do not observe that deterioration, and particularly if the leading measures broadly improve, our concerns about the economy would tend to abate. For now, we remain defensive.
In bonds, the Market Climate remained characterized last week by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of just under 4 years, largely in intermediate-term Treasury securities. I am not at all convinced that Treasuries with a maturity much past 5 years will provide adequate yields to maturity, or even positive real returns, as we move through this decade. But inflation concerns are clearly a longer-term issue. We are likely to observe strikingly larger budget deficits ahead for a while, but at the same time, the eagerness of investors to hold default-free paper is likely to be quite strong. In that environment, you can print a lot of government liabilities with seemingly no consequence.
It's in the back half of this decade where the eagerness to hold those liabilities will probably abate, with unfortunately no ability to reduce the supply since the dough will already have been spent. That will likely push us into an inflationary experience much like the 1970's, which followed the rapid increase in government spending and the move to persistent deficits after the introduction of the Great Society programs of the late-1960's.
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