Seeking Alpha
Profile| Send Message|
( followers)  

Once upon a time there were three little pigs. Eventually, the time came for them to leave home and seek their fortunes.

The first little pig graduated with a bachelor's degree in Babylonian Archeology and took the first job offered. He soon purchased a home with little money down and filled it with flat screens bought on credit.

The second little pig graduated, became a doctor, and bought the biggest home that he could (barely) afford. He made a lot of money and spent it as quickly as possible.

The third little pig, more entrepreneurial than his brothers, started a brick laying company. His capital being tied up in the fledgling business, he chose to rent an apartment as opposed to taking on the additional debt of a mortgage. He worked hard, his business prospered, and he lived within his means.

The first little pig saved little of the money he earned. But he knew more about sports than most reporters, watching every game played on one of his many depreciating flat screens.

The second little pig invested what little discretionary income remained. He opened accounts at all of the major brokerage firms. He liked their advertisements, and his brokers often took him golfing. He paid little attention to the fact that these brokerage firms (or their parent companies) had recently been downgraded by the ratings agencies because the pigs running the firms had lost control of their balance sheets. On the advice of his brokers, he bought into the Facebook IPO and watched his capital decline 15%. Oink.

The third little pig aggressively paid down the debt used to build his business. He saved everything else. He established a business relationship with a trusted advisor who took a methodical approach to creating and preserving wealth.

Eventually, the local economy soured. Conspicuous overconsumption fueled by access to easy credit, combined with an abject lack of household savings, was not a formula for financial success.

The community suffered. Thousands of pigs lost their jobs. The pigs running the community had no idea how to fix things. They collected taxes and gave it away immediately via stimulus and benefits programs. Only, these programs did little to incite growth. Moreover, once a pig gets a check, then that pig grows dependent on that check. And so the pigs running the community need more money so that they can write more checks. And so on.

Soon, the piggy community was up to their snouts in debt. So, the community sold bonds to those that could afford them. And then the piggy community used the proceeds to finance its activities, handouts and expenses.

Soon, there were very few pigs who could afford the bonds. And the banks and brokerages could ill afford the bonds either. Partly because these firms owned derivative instruments designed to profit on the community's failure.

So, the piggy community began selling bonds to whoever would buy them. Other communities eagerly stepped up. The sheep bought some. As did the lemmings. But the wolves bought the most.

The wolves, spendthrifts that they were, began to buy lots of bonds. In fact, they soon became the pigs' single biggest creditor.

After a while, the sheep, lemmings and wolves stopped buying bonds. So, the pigs raised the interest rates in order to attract more buyers. The sheep bought some. The lemmings followed. Yet, the wolves held out. Forcing the pigs to raise rates even further. Only then did the wolves, hungry for yield, buy more bonds. Lots of them.

Eventually, the pigs realized their mistake. They had used debt to fund all of their activities and programs. When the interest on the debt began to cost more than many of the programs themselves, the piggy community needed additional funds. And so they raised taxes. Only, most of the pigs (like our first and second little pigs) were broke.

Only the third little pig could afford the additional tax burden. Only, he had seen enough. Tired of footing the bill for his lazy, profligate brothers, he sold his business and moved to a community with fewer pigs.

Finally, the wolf came to town. He was not so big and bad. But he was smart. And he knew that the pigs were losing their ability to pay the escalating debt interest. So, he wanted his money back.

When the pigs refused, the wolf got mad. So, he huffed, and he puffed, and he sent the yields on their bonds soaring. At that point, the pigs could no longer afford their debt. And so the banks stopped lending. Which hurt all of the pigs that owned businesses. Which put more pigs out of work. Causing many pigs to lose their homes. Bringing the pigs running the community to further raise taxes. And so on.

Moral?

When pigs build homes of sticks and straw, they should expect a visit from the big bad wolf. Sometimes he huffs and puffs. Sometimes, he grants a temporary reprieve. But, as long as the wolf has a taste for bacon, he'll always return. Until all the pigs have been slaughtered.

Likewise, until western nations get serious about deficit reduction and deleveraging, memories of the 2008 market meltdown will lurk, wolf-like, just beyond the treeline. Stoking investor fear.

Brokerage commentaries and ICI fund flow data shows that institutional strategists and households alike have bought into the fear. Both continue to beat a bearish drum, favoring debt over equity. Yet, when interest rates reverse, or the debt overhang worsens, those bond funds will collapse like straw homes facing gale force winds.

The ongoing fear migration from equities to fixed income will, counter-intuitively, likely send U.S. investors back to the slaughter houses. Because after a decade-long bull market, debt is less a safe haven than it once was.

Bonds will correct as interest rates rise, or the vigilantes have their final say with our hyper-leveraged, three-legged house of cards: sovereign governments, global banks and western households. Each has saved to little and spent too much. And like any overleveraged, low-growth entity, will be forced to reconcile their imbalances.

U.S. investors must face their fears. Build portfolios from the bricks of the U.S. economy. Large cap companies paying generous dividends. Mid cap companies offering generous future growth prospects. Real estate investment trusts offering a bit of both. Indexes like VYM, VO and VNQ bolstered by well placed sell stops, can fortify a portfolio. And keep the wolves at bay.

Disclosure: I am long VYM, VO and VNQ.

Source: The 3 Little Pigs Economy