The last two times the S&P 500 Index hovered within striking distance of a new high at year end was December 2001 and December 2007. Both times the index level went on to see double-digit declines of 47% and 58% respectively. Roughly speaking, both experiences required five years of 100% rallies for stock indices to get back to even. With the benefit of hindsight, we know the end of 2001 and 2007 would not have made for a great buying opportunity in stocks. But both times would have been a great opportunity to settle for the safety of bonds.This time around, because of something called “financial repression,” the market dynamics look much different. Consequently, Dark Horse Wealth believes investors should be cautiously optimistic about stocks and increasingly skeptical about bonds.

It is true there is long list of possible macro economic risks that could derail the stock markets. Some of these risks are the “debt ceiling” nonsense, a deeper recession in Europe or re-emerging geo-polical instability in the Middle East. When combining the psychological impact of the stock market carnage with the above risks, it is no wonder investors have not left the safety of bonds. Consequently investors are likely over allocated in bonds and possibly under allocated in stocks. 2013 could be the year this dynamic finally re-adjusts driving stocks higher.

At the same time, the high credit quality bond market doesn’t offer the same safety cushion it had in 2001 or 2007[1]. At the end of 2012 high credit quality bond market offered investors a mere 2%. A far cry from the 5% to 6% rates seen in 2001 and 2007. Worse yet, the lack of interest rate cushion is only a small part the reason investors should be skeptical of bonds.

Bonds use to be a simple solution to conservative investing, but that principal needs to be re-thought. Simple bond mathematics reveal that the low returns in bonds are probable and the prospect of negative returns is far greater than it has been in a very long time. If interest rates end 2013 at the same 2% level they started the year at in the high grade taxable bond market, investors should expect a return of appoximately 2%[1]. A 1% interest rate rise would result in somewhere around a 3% loss[2]. A 2% rise would result in approximately a 8% loss[3]. The optimistic outlook for stocks is supported by more than just the idea that bonds aren’t a viable alternative to stocks.

The most obvious reason to be optimistic regarding stock markets and skeptical of bonds is due to Federal Reserve Bank’s (FRB) money printing programs called “quantitative easing” (QE). Using the newly created money, the FRB adds artficial demand to bond market which keeps interest rates low, thus hurting bond investors returns. This program has been supportive of stocks and other risk assests so far and will likely continue to be so. FRB Chairmen Ben Bernanke has indicated he will keep printing until unemployment comes down to 6.5% which at this point he projects won’t happen until 2015. The implication about the  size of the new money printing program, which has been coined “QE3,” is therefore opened-ended. It likely means at least another trillion dollars of liquidity will be added to the market. There more fundamental reasons to get optimistic and the US economy and subsequently stocks.

There is an excellent reasons to be optimistic. Energy costs are one of the primary drivers of economic growth. At the end 2001 and 2007, energy prices were on the move upward putting downward pressure on the economy. In 2013 energy prices may be contained and perhaps may continue to fall due to an energy production boom in US. Lower energy prices will also help subdue the volatility of inflation. Inflation stability correlates positively to the outlook for stock markets—meaning above average stock returns. Higher energy supplies and lower energy prices would help stem at least some of the negative inflationary pressures that could result from FRB QE (money printing) policies.Caveat emptor, buyer beware, if energy costs can don’t remain stable, and rise too quickly, the outlook for risk assets such as stocks, will be heavily tempered.

Commentary Conclusion

A policy of “financial repression” has been implemented and it is changing the face of the traditional investment landscape. With the curtain pulled back, you can see

that these policies are being implemented to de-leverage the federal government’s indebtedness at the expense of savers and investors.

For a policy of financial repression to work, artifical demand for government bonds needs to be created. Interest rates need to be capped and remain consistently below the rate of inflation. To US policy makers inflation is the best solution to boosting the revenues. All of this needs to be done while simultanously maintaining  an orderly and stable economy. Investors must deal with the realities resulting from this policy of financial repression.

The resulting realities of financial repression? Investors will increasingly be pressured to take more risk and/or lower their expectations for their retirement lifestyle. Ultimately investors will either get sick of low returns in bonds or understand they come with greater risk. This will force them to reduce their portfolio’s bond allocations. That money has to go somewhere! I believe these marginal sellers of fixed rate investments will be forced to becomes marginal buyers of other types of invest able assets. Maximizing safety and income remain their priority but they increasing be look for alternative solutions.

My investing thesis is that this process will drive up value in the “risky assets” i.e. STOCKS, particularly high quality dividend stocks and simultaneously put downward pressure on traditionally conservative investments such as bonds.

Some sophisticated investors have already shifted into riskier assets, such as high yield bonds, and thus you may think this move has already occured. This is, however, just the end of the open innings of financial repression. This repressive  policy is not understood by most mainstream investors who are still huddling in bonds, are scared of stocks and don’t understand the diversification and hedging benefits of gold. The key to 2013 and beyond will be how investors go about adjusting to financial repression.

“The Liquidation of Government Debt” by Carmen Reinhart provides a more detailed historical description on financial repression policy implemention and outcomes.

Steps to cope with financial repression

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