ARROYO GRANDE, Calif.
(MarketWatch) -- Worried? You bet. Drumbeats pounding: "Recession! Bear!" The voice in your head's getting louder, echoing comic-strip antihero Dilbert's worst-case-scenario in 2002 during the last recession: "I'm broke," said Dilbert, "my 401(k) savings are worthless." Yes, fear's a killer.
But his trusty adviser, Dogbert, had good news: "No. I've been impersonating you and diversifying your investments into tobacco, sweat shops, and diamond mines." Dilbert's eyes lit up: "Really?! How am I doing?" Then Dogbert, a comedic version of Wall Street's "greed is good" Gordon Gekko, summarized Dilbert's future: "It's mixed. You've made a 37% return. But your soul will burn for eternity."
Sorry folks, I can't promise you 37%. But I promise you won't have to pay big commissions to some Wall Street Dogbert or sell your soul for high-risk "alternatives" in the coming bear-recession. Solution: Bonds! History suggests a rally.
But before I get to that, if you don't believe a bear recession's coming, stop reading. But remember the happy-talking bulls: Just a few weeks ago guys like Countrywide's CEO Angelo Mozilo said: "Nobody saw this coming." About the same time both Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke were telling us that the subprime problem was "contained." Now, suddenly it's a "contagion" fueling "recession" fears.
The truth is, "everybody saw it coming," especially Wall Street's happy-talking bubble-blowers. They love bubbles because they make billions during the blowing -- and the popping. Even the chief bubble-blower of today's housing/credit mess, Alan Greenspan, finally admitted on "60 Minutes," while discussing his new book "The Age of Turbulence," that he "really didn't get it until very late." He was blowing this bubble for years, praising ARMs, ignoring reset risks and misleading investors by dismissing early signals of the coming housing bust as just a little "regional froth."
Folks we're in deep trouble when our leaders don't get it. We've had three blind mice at the helm running the "Good Ship American Economy" aground, first Greenspan, now Bernanke and Paulson, all wishful-thinking politicians ignoring reality. How could they miss? Back in mid-2005 The Economist magazine was blunt about the coming recession:
"Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000" with an estimated $30 trillion added worldwide in the last 5 years, to $70 trillion. "The worldwide rise in house prices is the biggest bubble in history, prepare for the economic pain when it comes."
Yes, pain! Lots, warned former SEC Chairman Arthur Levitt on The Wall Street Journal's Op-Ed page a couple weeks ago: "In terms of market meltdowns and the degree of pain inflicted on the financial system, the subprime mortgage crisis has the potential to rival just about anything in recent financial history, from the savings and loan crisis of the late 1980s to the post-Enron turndown in the beginning of this decade."
And still, the happy-talk continues unabated from America's perma-bulls. The headlines of two columnists in the latest Forbes read: "Subprime Risks: Overblown." Another touts "The Fall 2007 Rally." They're in denial, folks, ignoring an aging bull sitting atop a big fat housing bubble that Wall Street's been hyping for five years. Yes, the Fed can drop rates, delay the pain. But sooner or later, all bubbles explode. And later means more pain.
How much will housing prices collapse? Economist Gary Shilling, another Forbes regular, has also been predicting that housing will collapse into a recession for a few years. In January he said a "25% decline in house prices nationwide is not a wild forecast, and may be optimistic. Indeed, a 38% fall would be needed to get house prices back in line." He also predicts a "Treasury bond rally."
Yes, a bond rally. Recent history offers powerful lessons. Please look very closely at the see-saw ride between Fed rates and total bond fund returns as they swing in opposite cycles:
1989-1993: Fed rate down, bonds rates up
The Fed rate collapsed from 9.25% in 1989, leveling off in the 3% range through 1992-1994. As a result, the average bond fund returns rebounded to roughly 7% in 1992 and a healthy 12% in 1993 as the Fed rate moved sideways.
1994-1995: Fed rate up, bonds rates down
The Fed began raising rates in early 1994, topping at 6% in February 1995. Those seven quick increases spooked the bond market. As a result, in 1994 total returns dropped into negative territory, roughly a minus 6%.
1995-1998: Fed rate down, bonds up
Then the Internet took off in 1995, driving a new bull. Fed rate increases halted, were cut back slightly from 6% to the 5.5% range, which held through 1995-1998. Confidence was high, and total bond returns shot up to the 20% range and fell back. In late 1998 the Long-Term Capital Management fiasco rattled global markets. The Fed rate dropped to 4.75%. Bond returns were roughly 4%, 10% and 6% respectively for 1996 through 1998.
1999-2000: Fed rate up, bond rates down
The glory days of the go-go dot-com insanity carried into the first quarter of 2000. Meanwhile, the Fed tried to dampen the mania hiking their rate from 4.75% in late November 1998 to 6.5% in May of 2000 when the Nasdaq peaked above 5,000. As the Fed rate rose, the bond market collapsed and the recession was underway.
2000-2002: Fed rate down, bonds up
Following the grand tech crash in the spring of 2000, Fed rates dropped like a rock with 11 cuts from 6.5% to 1% in June 2003. The bear roared. Irrational exuberance died. During this 3-year bear recession, bond funds became a safe haven, far outperforming equities with average returns of 9% in 2000 and around 8% in 2001 and 2002.
2003-2007: Fed rate up, bonds down
Then the Fed began its quarter-point rate increases from 1.25% in mid-2004 up to 5.25% where they've held steady since mid-2006. Stocks rallied. As the Fed rate increased, average bond returns predictably declined into a 2% to 4% range during this period.
2007-2008: If Fed rate drops, will bond returns increase?
Depends on when the Fed will buckle under market pressures. Yes, they will, although the Fed's usually behind the curve at turning points. But if history's any guide, the bubble's guaranteed to pop, the aging bull will expire and the next phase of the cycle will naturally begin, namely a bear market and recession. That will force a drop in the Fed rate ... and bond returns will start looking real good.
But when's the best time to get into action? That's tricky. Fed Chairman Greenspan warned about "irrational exuberance" back in 1996. Few listened. Wall Street loves blowing bubbles. So it was four years before the bubble burst. But remember, we've been hearing warning bells for over two years.
So listen to Shilling's latest: As "lethal subprime ARMs reset ... highly excessive inventories will devastate housing prices" by at least 25%, assuring a "massive consumer retrenchment and a major recession that would spread globally. Decelerating consumer spending suggests a downturn by year's end." Even Dilbert can figure that one out!
