Investors are mistakenly shifting from a credit stressed mindset to focusing on the general trend of the American economy. Today’s unemployment report, which was quite bullish, throws more fuel to the big rally now underway since March.
I have been highly suspicious of this post-March 17 global stock market rally. World markets are now down just 3% in 2008 and have nearly erased their entire post-January losses in just six weeks of trading. But, as I have commented here before over the last few weeks, this rally has dangerous undertones and investors should remain cautious. Key credit market indicators remain clogged or still illiquid, highly bruised and unlikely to recover any time soon.
It is quite obvious that market participants have thrown in the towel at this point, lunging after stocks following five straight months of losses from October to March. Treasury bond yields, which benefited from their safe haven status, are now correcting heavily, from yielding just 3.31% in mid-March to 3.85% this morning. Investors are unwinding their defensive hedges in T-bonds, foreign currencies and, of course, gold. Most commodities are also heading south after huge gains, including oil.
But there is also some serious unwinding occurring in the credit markets. And that process will take several years to complete. Investors fail to understand that an unwinding process has begun since last fall. Debt deflation is the most formidable policy challenge the Federal Reserve has faced since the Volcker Fed wrestled high inflation in 1981-82.
It is a big mistake to believe this will be a quick v-shaped economic recovery. I am betting the United States will endure a 12-18 month slowdown or a u-turn recession, lasting much longer than has been discounted by the markets. The lethal combinations of deflation in housing and bank credit contraction coupled with soaring inflation for food and energy will remain formidable hurdles for corporate earnings and domestic consumption. If I am right, this rally will probably end in a very bad way before the summer is over. That event will probably mark the true bottom for stock prices worldwide.
Another point worth heeding: bear market rallies are perfectly normal and expected following big declines. That is exactly what has been happening since March. And guess which sector is leading this recovery? The banks.
Though some segments of the credit markets have rallied, namely junk bonds and mortgage-backed securities, the rest of the complex is still stuck somewhere in cyberspace. Auction rate securities, LIBOR, commercial paper, leveraged loans and CDOs, or collateralized debt obligations, are still sitting on the books of major financial institutions. There is more bad news coming.
The stock market might be lighting firecrackers, but most pundits and investors still fail to appreciate the severity of this crisis. I will not underestimate the consequences of two extreme economic anomalies now riding side by side for the first time since 2001: inflation and deflation. I'm still invested, but my exposure remains the lowest since early 2002. I'm also still a big believer in gold.
Have a good weekend. See you on Monday.
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