Bond Information Cast in a New Light

by | Dec 12, 2008 | Multi Currency Investing

Some of our greatest lessons come from the things we see in new light cast by new information.

Take, for example, a lesson from last year that answered a reader’s question:

Dear Gary, We are subscribers to your portfolio educational services & attendees to your Ecuador business made easy event in 2005. I was looking over your new portfolios for 2008. I was surprised that they did not contain a bond portfolio, as in years past. Why quit on bonds now and go with only equities? Stock markets around the world are coming off all time highs? Best Regards,

My reply reflected information I had garnered over the past two years of our study in the real markets.

Here is what I replied:

This is a good question about bonds.  In my Nov. 12 message I wrote about two of the six portfolios we are tracking:

“Blue Chip Portfolio. One prominent feature we saw in the portfolios we tracked these last two years has been the panics. The world is not convinced yet that emerging markets are the places to go. Plus emerging markets are highly leveraged, especially with Japanese yen loans. One lesson we learned from the panics of the last two years is that equities recovered the best after each panic.  There are many scenarios we can imagine that will cause a 2008 panic including further fallout from the sub prime loan disaster, a slowing US economy and over $100 a barrel oil.  Last go round investors fled to US dollar bonds. As noted above the flow to US dollars last July could have been the last time in our lives, that we will see a rush for safety into the US dollar. If there is a 2008 panic we are thinking that investors will flee into Blue Chip, mainly non US dollar, equities…and this portfolio will do well.

“What we have seen in the last two years is that equities recovered much faster than bonds after the panics. From this fact and the realization that bond returns may not be sufficient to make up for a falling US dollar, we selected this portfolio rather than one in bonds.

Here is a review of asset class performance  over 95 years.  The assets compared are Equities, Housing, Bonds, T- Bills and Silver. Over the entire 95 years the returns on these asset classes was:

Equities: 11.9% per annum
Housing:   6.7% per annum
Bonds:      4.8% per annum
T-Bills:      4.6% per annum
Silver:       4.2% per annum

So long term equities were the best investment to hold. Hard assets the worst.

However the results were very different when the economy was split and viewed in four different conditions, Stable. Moderate Inflation, Rapid Inflation and Deflation.

During “Stable Times” the returns of the asset classes were:

Equities:      14.0%
Housing:        5.9%
Bonds:           5.3%
T-Bills:          3.1%
Silver:            0.7%

In “Moderate Inflation” this barely changed to:

Equities:     14.0%
Housing:       5.9%
Bonds:          5.0%
T-Bills:         4.6%
Silver:           0.7%

“Rapid Inflation” brought huge changes:

Equities:         9.6%
Housing:         7.0%
Bonds:            3.6%
T-Bills:           5.0%
Silver:           17.9%

“Deflation” brought even greater change:

Equities:          -6.2%
Housing:          -0.5%
Bonds:              4.8%
T-Bills:             4.6%
Silver:            -15.3%

Our view in constructing these portfolios for the year ahead are that we are more likely to see rapid inflation rather than deflation.  This means that bonds are the worst possible investment to hold.

New light is cast on this matter in two ways…the first from the performance of the portfolios we tracked in 2008.

Green Portfolio    Oct  2008    -56.08%    Nov 2008  – 208.91%
Emerging Market Oct  2008    -73.79%    Nov 2008  -131.78%
Dollar Short         Oct  2008    -35.21%    Nov 2008  –  58.50%
Danish Health     Oct  2008    -92.18%   Nov 2008   -146.81%
Infrastructure      Oct  2008   -112.00%  Nov 2008   -224.73%
Blue Chip             Oct  2008   – 79.21%   Nov 2008   -146.47%

The Blue chip portfolio actually performed worse than the emerging market portfolio!

The second new light is based around the numbers that outline a battle between inflation and deflation.  Let’s get a feel of the numbers that are in play.

We can get a feel of this struggle from a December 11,2008 USA Today article entitled Federal share of economy soaring by Richard Wolf.

The article says that economists warn that the fast pace of US government spending could spell trouble in the future: slower economic growth, higher interest rates, and the likelihood that tax increases or spending cuts will be needed to tame a budget deficit headed toward a record $1 trillion.

Compare this to the mid year review of the Federal budget (July 2008) issued by the White House which puts federal income at a bit over 2.5 trillion dollars in 2008.  During a recession we should expect that income to drop.

The USA Today article states that the US economy amounts to 14.4 trillion dollars a year.  The article points out that government spending has grown to 25% of the economy.  One of every four dollars spent in America is by the government.  This is the highest since WWII.

Inflation occurs when money created when there is more money than products.  Deflation occurs when there are more products than money.

So, let’s guess. If the US economy contracts 7%, that is a deflationary force of 1 trillion dollars.  If the Federal government  spends a trillion dollars more than it has that is an inflationary force of 1 trillion.

I think this is a little more complicated than this, but I am thinking the numbers through and will be studying this. let me know any thoughts you have as well.

Let’s start with this 7% as a bellwether.  Assume government deficit (not debt-which is much more and another concern) of 1 trillion.  If the economy contracts more than 7%, expect deflation.  If the economy contracts less than 7%, expect inflation.

This is the beginning of our inflation/deflation model and we’ll expand from here.

In the meantime, do not liquidate all your bonds.  High quality short term bonds may be really good investments now.

Until next message, may your new lights always be good.


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