Should you buy bonds?

Equities may rally somewhat from near-term deeply oversold levels in the very near future as the period between July and August is characterized by some seasonal strength. However, we would use any additional strength as a selling opportunity, as the upside would seem to be very limited as substantial resistance resides on the S&P 500 at between 1290 and 1325.

While I am very negative about US bonds and the US dollar in the long run, for the next three months, US bonds could outperform equities. But why! After all US bonds and also other bonds around the world have been declining in price since the summer of 2005, and have grossly under-performed global equities since 2003. Moreover, we read every day in the media that inflation is accelerating.

Two observations! After each bubble peak some economic pain followed for the bubble sector. Japan went after 1989 into a 14 years deflationary period and economic stagnation, and the high tech sector suffered from over-capacities and weak pricing following March 2000. So, should we expect a housing slump?

Housing slowdown

There are several indications that the housing sector is slowing down rapidly and may start to have a negative impact on the economy. Housing affordability is at the lowest level in fifteen years.

The reason for housing affordability to be down so much is that while home prices rose rapidly in the last five years, income gains for the typical household - not for the hedge management community - have either been stagnating or declining altogether.

Moreover, as interest rates rose from 1% on the Fed fund rate in June 2004 to currently 5.25%, financing cost has escalated. Poor affordability aside, the inventories of unsold homes and especially of condos have been rising rapidly while home buying attitudes have been declining.

It should be noted that, in the past, housing starts have been one of the most reliable indicators of future economic activity as the home building sector has a tremendous multiplier effect. It directly impacts the appliance, furniture, home improvement, consumer electronic, and construction material industry.

Moreover, it stimulates financial intermediaries and the real estate brokerage industry and allows households to refinance and extract money from their homes by taking on additional mortgages- a large part of which was spent on consumption.

Housing multiplier

My view would therefore be that the coming housing slowdown or slump could actually significantly exceed expectations and lead to across the board economic weakness. Don't forget that if home prices no longer appreciate, home equity extraction will come to a halt.

The consumer will then likely have to begin saving again from current income. Both these factors would obviously depress consumption and retail sales. One more point! The weak sales growth at Wal-Mart seems to confirm that the typical US household is already struggling.

So, what are the investment implications? All indictors point to an economic slowdown, but what we do not know is the reaction of the Fed to such a slowdown. No further tightening or an easing of monetary polices in a few months could result in further US dollar weakness measured against gold on concerns that the Fed will rather fight economic weakness than inflation.

This would obviously not be favorable for bonds and also likely have a negative impact on equities if measured against gold. Alternatively, it is possible that sudden weakness in economic activity could lead to a further sharp decline in industrial commodity prices and, so, ease inflationary pressures and meaningfully improve sentiment toward bonds.