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"Sell T-Bonds"

Regulation's attack on the 'Prudent Man' is only one more reason...

THE KINDER, GENTLER version of American capitalism that has come into fashion since last year's credit crisis is neither kind nor least not to capitalists, writes Eric Fry in the Rude Awakening.

The "new capitalism" visits the sins of an imprudent minority on the backs of a prudent majority. And instead of causing the members of the imprudent minority to atone for their sins by forfeiting the wealth, status and employment they deserve to lose, the prudent majority must make atonement by suffering a growing burden of regulation and taxation.

Won't the guilty parties also face rising regulation and taxation?  "Not really," is the short answer. Congress will pass punitive and restrictive measures with the offenders in mind. But the offenders still retain the mega-million-Dollar operational budgets that provide armies of securities lawyers, tax lawyers, tax accountants and compliance personnel to repel the effects of regulation and taxation.

Therefore, the burden of increasing regulation and taxation becomes a kind of regressive tax that falls disproportionately on those with fewer resources at their disposal. For example, an independent brokerage firm with 30 employees faces the same regulations as Goldman Sachs. But the relative cost of compliance is MUCH higher for the small firm that lacks Goldman's resources, budget, connections etc.

Woe to the independent firm that fails to comply with the letter of each regulation. That firm will likely be audited, fined and/or prosecuted into extinction by regulators. Conversely, no regulator would dare to threaten the survival of a large firm, no matter how often and egregiously that large firm may have violated the spirit of every applicable securities law.

Didn't the large securities firms just spend the last several years violating the spirit of the "Prudent Man" rule that has guided professional investment practices for decades? And didn't these large firms just lose hundreds of billions of Dollars in the process? But other than Lehman Bros., none of the offending firms went out of businesses. Nor did any of the offenders' officers go to jail...or even lose a country club membership.

Instead, the offenders received trillions of Dollars of bailout funds and guarantees, while also retaining their access to preferential financing, selective securities laws exemptions, highly placed friends in government and "too-big-to-fail" status. These perversions of capitalism serve to slant the playing field toward those who least merit preferential treatment. Therefore, these perversions of capitalism serve to destroy – or at least erode – the all-important "right to fail" that has enabled American capitalism to flourish for generations.

Gone are the Absolute Laws of economic cause and effect. Gone are the Darwinian processes that reward prudence and punish recklessness. Most of the "fittest" still survive, at least to those who can endure the burdens of regulation and taxation, but so too do many of the "un-fittest".

Individuals, investors and corporations continue to produce the same range of successes and failures that their predecessors made over the preceding decades. Thus, the capitalistic processes of wealth accumulation, reinvestment and/or speculation continue to spit out winners and losers, just like they always have. But in the modern era, the losers don't always lose...or, at least, they don't always lose completely. Instead, the rule-makers sometimes change the rules midway through the game...or start the game all over from the beginning.

Unfortunately, changing rules to avoid a crisis has the unintended drawback of perverting the simplistic process of cause and effect. And if you change the rules often enough, nobody wants to play anymore. The participants either figure out ways to cheat, or they refuse to play the game at all... and search for some other game where the participants "play fair".

A buyer of common stocks, for example, might begin to prefer Russian securities over the American variety. After all, if neither jurisdiction will reliably and equitably apply securities laws, why not invest in the Russian issues that carry much lower valuations and much higher growth prospects? Or to put it another way, if both jurisdictions will behave capriciously – handing out favors to cronies, while bending long-standing laws and regulations in the name of expedience – why pay a premium for American equities?

Similarly, the buyer of global sovereign bonds might begin to ask himself why he should prefer a low-yielding US Treasury bond to a higher-yielding bond from an issuer like Brazil. This bond buyer might begin wondering why he should continue investing in the Dollar-denominated securities of a government that is on track to pile up a massive $2 trillion deficit this year, rather then investing in the real-denominated securities of a government that is running a primary budget SURPLUS.

Brazilian bonds aren't risk-free of course, but neither are Treasury bonds, despite their flattering AAA rating. At the very least, the yields on these two credits might converge, providing a much higher return to the buyer of Brazilian debt than to the buyer of Treasurys.

Why do we bother musing about these subtle changes unfurling across the global macroeconomic landscape? Simply because these changes influence investor behavior over time...and as investor behavior changes, so do financial asset prices, for better or worse.

Most changes occur very slowly, of course, and proceed in nearly invisible a glacier that carves a path down a granite mountain. But the results of these incremental changes are no less dramatic for having occurred very slowly. In fact the opposite is true. The thing that almost no one notices is the thing that moves mountains...often until the mountains land atop the unsuspecting and the unaware.

US Treasury bonds are a "Sell" more than ever.

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Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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