As a direct result of the financial crisis of 2008, the Frank/Dodd Wall Street Reform Act was passed to try and reduce the risk of banks’ failing during a financial crisis.  One of the unintended consequences of the Act was that it has reduced liquidity in the bond market.  How?  Before Frank/Dodd, banks were active dealers in bonds and provided much needed liquidity to the bond market.  Under Frank/Dodd, banks were forced to reduce their balance sheets and are no longer providing liquidity for the bond market.  This has not been a problem for the bond market the past couple of years because of the high number of individuals who have been buying bond funds.  This has provided the needed liquidity for the time being.

The question is what happens when individuals begin to sell their bond funds?  This is a concern not only for us, but for the Federal Reserve.  Just two weeks ago, it was reported that the Federal Reserve is contemplating charging exit fees on bond funds.  Why?  To discourage investors from cashing out their bond funds.  Even though the Federal Reserve is considering this move, it has no jurisdiction over mutual funds, the SEC does.

One of the biggest reasons for the 2008 financial crisis was a lack of liquidity in the bond market.  It was worse than a house on fire.  When a house is on fire, you simply exit the house.  In a financial crisis, in order to “exit the house” you need someone to take your place by buying your asset.  This becomes difficult if prices are falling.  Remember, the purpose of the Frank/Dodd Act was to prevent another 2008 crisis.  By reducing liquidity in the bond market, it might just have the opposite effect.

What does this mean for Investors?

We do know that the Federal Reserve is concerned about the winding down of quantitative easing and the impact it will have on the market.  If it wasn’t, exit fees on bond funds would not be a discussion point.  If the SEC does place exit fees on bonds funds, it would likely cause a run on bond funds (which is exactly what the Federal Reserve does not want to happen) before the fees are instituted.  If a change does happen, it likely will happen quickly in our opinion in order to minimize the chances for a run on bond funds.  It is wise, therefore to have some cash available for emergency purposes.

Book of the Month –  “Tomorrow’s World”, Clint Laurant

There are few certainties about the future, except for demographic shifts.   This book gives a picture of the world 20 years into the future.  The aging population is a global phenomenon.  The global change in age groups over the next two decades is as follows: 0-14 year olds will drop by over 60 million and 15-24 year olds will drop by 29 million.  The 40-64 year olds will increase by 352 million and 65+ crowd will increase by 435 million.  This book provides a lot of facts and figures, but is important for anyone in business, investing or buying real estate.  Teenage games and accessories will not be a growth business over the next two decades.   However, leisure and travel will be as those over 65 tend to spend more money on “experiences”.  The book also shows how growing economies like China will slow down significantly because of demographics.  Currently, 53% of Chinese households have no one under the age of 19 and this statistic will rise to 68% by 2032.  China also will lose on average 6.7 million workers per year over the next two decades.  That is a reduction of 135 million people over the next 20 years.

Interesting fact – The Russell 2000 Small Company Index’s stated P/E ratio was 21.2x on March 31, 2014.  This figure excludes companies that have negative earnings.  If you include companies with negative earnings, the P/E is a whopping 61.3x!

Sincerely,

Your THOR Team