Bonds Come Back

January 15, 2003

December was weak for stocks, but not as weak as one might expect given the torrent of bad economic and political news. The S&P500 and the Dow were both down just over 5%, as were small cap stocks, while the NASDAQ fell closer to 10%.

Bonds came back strong. Long-term government bonds were up over 4% in December; higher-risk bonds were less spectacular but not bad. As the sheer magnitude of the Bush economic stimulus package becomes evident, December may very well be the high point (lowest yields) for Government. We hope we're wrong.

On the surface, spending money is a great way to jump-start a weak economy. Ever since the government became such a large part of the economy (can you believe we didn't even have an income tax before 1913?) government tax and spend policy (AKA fiscal policy) has been used to "manage" economic growth.

In fact, in a perfect world, the Government would run a budget surplus when the economy is strong, and a deficit when times are tight. Doing so would flatten out the natural swings of an economy - swings that occur because people tend to get a little over enthusiastic when times are good, and a little too pessimistic when times are tough. Think of the government as a money sponge, siphoning off the excess cream from a bubbling economy, only to release the bounty when we really need it back.

The government once played a very minimal role in the economy. During one particularly dramatic period of economic euphoria, investors threw money at overvalued companies positioned to profit from new technologies. Companies expanded or merged to meet the demands of the new prosperity. The time was the 1920s.

Eventually the music stopped, and reality returned to the market. The shock of the stock market crash caused investors to become just as irrationally pessimistic. The result? Twenty-five percent unemployment and stock prices down 90% (and those were the good stocks).

Something had to be done, so the government began to take on its modern form of economic puppet master. Suddenly the government became the employer of last resort, with New Deal era plans in the 30s paying people to build things just to put them to work.

Today almost everyone agrees the government plays a role in the economic well being of the country, but everyone argues about exactly what that role is. When a government spends money, it generally targets supply or demand, sometimes intentionally, sometimes unintentionally.

Stimulating demand is simple: give money to people. Remember that Bush tax rebate check we all got a year or so ago? The idea of it was to stimulate demand, or buying behavior, because most people run out and spend the few hundred dollars they got on some new clothes or a night out.

Stimulating supply means spending money to help supply along. If the Government cuts tariffs on imported steel, steel prices would drop, which would lower costs to companies like Ford and GM. They in turn might lower the prices on some cars to compete with other car manufacturers. This is stimulating supply because the government spent money to help suppliers of items made with steel. 

But wait, the government didn't spend anything, they just lowered taxes. Economically speaking cutting taxes costs the government just as much as sending out checks. 

Generally its preferred to stimulate both supply and demand. If the Government just does supply, who is going to buy those cheaper cars? If the Government just does demand, they run the risk of causing inflation because they gave people money to buy stuff but nothing was done to increase supply so prices go up. Sadly, politicians, both Democrat and Republican, tend to favor stimulating demand while ignoring supply. Demand has more votes - there are only so many buyers of steel. Besides, some will criticize plans angled at business as corporate welfare (and sometimes it is).

What does this have to do with our current situation? 

Wall Street's 1990s decade was not that far off from the 1920s. In hindsight, it may have been prudent for the Clinton administration to sponge off a little more excess from the system (and run really big surpluses) and pay down the debt. This may have stopped some of the insanity of the late 90s, and the recession of the early 2000's. 

The trouble is, the current administration (who inherited a sinking economy) seems very good at spending money and cutting taxes, which can have a short term stimulating effect during a recession, but not very good at generating real economic growth. Besides the tax rebate handout of a few years ago, we've seen plans for massive tax cuts, both on income and dividends. The government is going to give you your money back. Who can argue with that logic? 

Get in line, in handout window is open for business! Trouble in the airline industry? How's about a few billion from Uncle Sam? Tough times from September 11th? How about some cash! Times are tough trying to keep a yacht running off meager after tax dividend payments, no problem, consider it cut! Kids sure are expensive, here's a tax break. Stock market down? We can juice that right back up with the right tax breaks. Giving people money is a darn good way to get reelected during tough economic times, but probably not a good way to get the economy singing again.

When you look at the lineup of fiscal policy initiatives, you just don't see that many you could point to that would encourage people to start new businesses, hire more people, increase spending, build a factory, work more hours, produce more goods, or in general lead to more and better goods and services. Without actually creating incentives to match the increased demand you could see inflation, something everyone thinks is licked.

Worst case scenario - and we don't see this happening because some should come to there senses along the way - is inflation and higher bond yields along with and even weaker dollar. Both would hurt investors in the long run, short term pops from a dividend tax cut aside. 

Not that you can do much about it, what with money market funds yielding a below inflation rate and real estate prices sky-high. Just grin and bare it and hope the economically touchy times go away, as they eventually will.

See what happens when the market gets back up to higher prices - we start getting bitter and pessimistic again. Next month MAXadvisor promises to be less of an investing party pooper.