The Rude Awakening
Wall Street, New York
Monday, September 18, 2006 ------------------------- - Sexy, high-yield slumber lies ahead for savvy bond
investors,
- Factories follow housing in the great un-boom,
- The American Spirit of Spanish volleyball beauties,
11,800 and counting for the Dow and plenty more...
------------------------- Eric Fry, reporting from the volleyball courts of Laguna
Beach... "Where are you from?" a fellow male volleyball player asked
the tall, lean brunette who had just perched herself on the
nearby boardwalk. "Barcelona," she smiled, tossing back her long hair in the
timeworn style of gorgeous, self-aware females. "I'm just
visiting some friends." "Really? You live in Barcelona?" "Yeah, my mom's Spanish," she replied, tapping a box of
"organic" American Spirit cigarettes against her palm. "What do you do in Barcelona?" "I model," came the expected reply. "Do you also play volleyball?" "Yep." "Do you REALLY play?" "Yep," she insisted. "My friend's gonna pay me $5 if I beat
you guys." "And if WE win?" he asked. "I don't know...maybe then YOU should pay me $5," she
laughed, "just for the pleasure of beating me." "I think I'd rather lose," he said. "That's good...cause I think you might." Your editor looked on as the two teams took the court. The
model and her male partner jumped out to a quick 6-0 lead
in a game to 15. The model was, in fact, very good...but
not 6-to-nothing good. Eventually, the all-male team
managed to stop gawking at their female opponent and begin
playing up to their abilities. They battled back to tie the
game at 15 apiece. But the model and her opponent stepped
up their game just enough to win the next two points...and
the game. The model and her partner were not the better team. But
they played the better game. They played a smart, safe game
that was just good enough to win. Beach volleyball, like
most sports...and like most investments, usually proves the
adage: The fewest mistakes wins. Over in the financial markets, both stocks and bonds are in
rally mode. Perhaps it is no mistake to continue buying
them both. But it might be. In particular, we think it be a
mistake to commit new money to long-term Treasury bonds.
And if it might be a mistake, we'd rather commit money to
short-term Treasurys, where the rewards are more certain
and the consequences of error are much less severe. The
fewest mistakes wins. --- Special ---
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By Eric J. Fry Bonds are the new "black." Suddenly, these boring financial
assets have become sizzling hot portfolio accessories.
Everybody wants to be seen with bonds, especially long-
dated Treasury bonds. But we suspect this investment
fashion is about to become "so last season." Please allow us to suggest an avant-garde alternative: The
bond-free portfolio. We wouldn't abandon fixed-income
entirely, however. In the place of 10- and 20-year
Treasuries, we'd accessorize a portfolio with baubles like
2- and 3-year Treasuries. Long-dated Treasuries have enjoyed a delightful rally since
late June, causing the 10-year yield to fall from 5.25% to
4.56%. Fueling this rally is the notion that the Fed is
finished...and so is housing. In other words, the Federal
Reserve has finished raising interest rates for this
particular "tightening cycle." The next move in short-term
interest rates therefore, will be down, not up. At the same
time, the crashing housing market is raising the prospect
of recession – a condition that usually causes bond prices
to rise, and yields to fall. In fact, the Federal Reserve does appear to have finished
raising rates...and the crumbling housing market does
appear to be dragging the economy into recession. The
rallying bond market, therefore, does not lack for ample
fundamental support. Even so, the "buy bonds" trade has
become so popular and "crowded" that a contrarian-minded
investor must consider alternative scenarios – like the
scenario that bond prices might not continue rising. It's true that the economy is visibly slowing. Just
yesterday, the Commerce Department reported that U.S.
factory orders in August (excluding transportation) dropped
0.7% - the biggest drop since February. Meanwhile, the
Institute for Supply Management (ISM) reported that
business activity at service industries in September
dropped to its lowest level in more than three years. Manufacturing industries tell the same story. The ISM
manufacturing survey for September touched its lowest level
since April 2005. 
"Excluding the April 2005 reading," observes Asha
Bangalore, the insightful economist from Northern Trust,
"one has to go back to July 2003 to see a comparable low
reading. Indexes tracking production, employment, supplier
deliveries, prices, backlogs, exports, and inventories all
fell in September...The overall tone of the report is that
factory activity is winding down, perhaps as a result of
the housing recession. To wit, a telling quote from the
September ISM manufacturing report was: 'Within the past
two weeks, [a respondent was] seeing a serious downturn in
customer orders related to the housing market downturn.'" Corroborating the ISM's downbeat assessment, residential
construction is dropping swiftly. "The July-August average
of residential construction outlays shows a 15.4% drop
after an 8.5% decline in the second quarter," Bangalore
notes. "In other related news from the housing sector, the
Pending Home Sales Index (PHSI) of the National Association
of Realtors...is down 14.1% from a year ago." 
Bond investors have been feeding on these plentiful signs
of economic decay like coyotes on a carcass. But the bull
case for bonds includes a couple of caveats. First, the
inflation rate many not slow as rapidly as bond bulls hope
and believe. Second, the U.S. dollar may not resist the
gravitational pull of our excessive government debts and
trade deficits. If the inflation rate remains stubbornly
high and/or the U.S. dollar resumes its downtrend, the Fed
could not easily justify cutting interest rates...even if
the economy required it. The third risk to bonds is a touchy-feely one: Bonds are
too darn popular. The latest CFTC Commitment of Traders
report shows that large speculators – a.k.a., the "dumb
money" – hold a record-high long position in Treasury-note
futures. Perhaps that's why one of the smartest bond
investors, Bill Gross of Pimco Asset Management, favors
short-term Treasuries over their long-term counterparts.
For the record, Gross does not dislike long-term
Treasuries, he simply likes short-term Treasuries much
better. 
"Currently," Gross remarked recently, "PIMCO's best 60/40
bet is a cyclical one that proposes that the Fed is done
and ultimately will have to lower rates in order to re-
stimulate an asset-based/housing-led economy...With
inflation leveling off at admittedly unacceptable levels
and the domestic economy moving towards a 2% real growth
rate or less in the next year or so, the Fed at some point
in 2007 will be forced to cut short rates.
"Don't ask us when or by how much yet" Gross continued. "A
lot will depend on the evolution of the domestic housing
market and the equally important maturation of the global
economy sans U.S. consumer imports and perhaps hyper
investment spending in Asia...The U.S. bond bull market,
which began almost two years ago, remains in its infancy.
But the best way to play it...is the front end of the
curve." One way to express a bullish opinion on short-term
Treasurys would be to buy the iShares Lehman 1-3 Year
Treasury Bond ETF (NYSE: SHY). At the current quote of
$80.26, this ETF yields just under 4%. Alternatively, the
2-year Treasury note itself, yields 4.61%. The bond bulls may be right, of course. In which case they
would probably reap a greater reward than would the buyers
of SHY. On the other hand, the bond bulls might be wrong.
In which case, the buyer of SHY would still receive an
attractive yield...and many restful nights. We think high-
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