Do you think the recession is over?

I must admit that I received this question a few months ago, but it seemed appropriate given recent news.

The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) announced this week that the recession officially ended in June 2009.  The NBER is very slow to declare the end of a recession – typically it takes six to 18 months after a recovery has taken place – to ensure accuracy.  The NBER said the recession that started in December 2007 lasted 18 months, the longest since World War II.

Although textbooks will refer to June 2009 as end of the “Great Recession,” much of America is still feeling the pain.  The unemployment rate remains historically high and productivity gains are preventing job creation.  When including underemployed and discouraged workers, the unemployment rate is a startling 16.7%. 

Meanwhile, Americans’ wealth remains $10 trillion, or 15%, below the yearly peak reached in 2006. Home prices (many Americans’ biggest asset) remain brutally low and will remain under pressure as more homes enter foreclosure.  The IMF estimates that 11 million homes are worth less than their mortgages, with 7.6 million heading to or at risk of foreclosure.

Recoveries from financial crises tend to be weaker than “normal” recessions because banks as well as individuals must for through the long process of repairing their balance sheets.  According to The Economist, this period of debt reduction lasts around seven years, which means America would emerge from this process in 2014. 

Yes the recession is over, but the recovery is going to be bumpy with many fits and starts.

Do you think there is a bond bubble?

A remarkable amount of investor dollars has piled into bonds in recent years.  Painfully slow economic growth and a longer period of rock-bottom interest rates will only magnify this trend. 

Investors’ appetite for bonds has been driven by increased risk aversion, low yields on cash, and higher savings rates.  Demographics also play a role, with baby boomers seeking safety over higher returns as they near or are in retirement. 

Are bonds in a bubble?

Bubbles are masked by euphoria, which makes them hard to identify until they pop.  With so many publications and media outlets raising this question, I’d say bonds (broadly speaking) are not a bubble.  That said, I don’t expect great returns from bonds in coming years.  Current yields – historically a good proxy for future bond returns – remain ultra low.  If interest rates or inflation rises even the slightest bit, then prices will get whacked.

I’m not suggesting you sell all of your fixed income investments because of some potential price fluctuations.  After all, prices changes play a very small role in bonds’ total return.  I’ve used the chart below before, but I think it makes a great point.

According to Charles Schwab, more than 90% of total return since 1976 generated from a broadly balanced portfolio of U.S. investment-grade Treasury, agency and corporate bonds has come from interest payments as opposed to change in price.

I don’t find bonds to be a great value, but they still play a critical role in every portfolio.  If you are worried about price declines, then there are some things you can do to protect yourself.

For starters, avoid long-term bonds and focus your fixed income portfolio bonds with shorter duration.  Long-term bonds tend to have slightly higher yield, but their standard deviation (volatility) is almost twice as high as intermediate-term bonds.  I’d also avoid high-yield (junk) bonds, which are trading above par value for the first time since June 2007.  Investors buying high-yield bonds are usually after income, but yields today aren’t high enough to appropriately compensate investors for the risks being taken.  Remember, this part of your portfolio is for stability rather than big return.

Peter Lazaroff, Investment Analyst

www.acrinv.com

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