Wednesday, April 4, 2012

DOW -124 = 13,074
SPX – 14 = 1398
NAS – 45 = 3068
10 YR YLD -.04 = 2.24%

OIL +.57 = 102.04

GOLD – 25.40 = 1621.40
SILV – 1.32 = 31.46
PLAT – 43.00 = 1604.00

So, we made it through the first quarter, and it was just delightful, one of the best first quarter rallies in years; the S&P up about 12%, the NASDAQ up 18%. Do you think the S&P will continue at that pace in the second, third, and fourth quarters? Do you think the S&P will gain 48% this year? Actually a bit more. Do you think the NASDAQ will gain 72%? Let's sort through what it really means. Are we seeing recovery or was it just a cyclical bull in a secular bear? Remember hearing about green shoots? Remember when they withered on the vine? How do recognize a genuine, sustainable recovery?

First you have to realize there is an economic ebb and flow and there are some fairly predictable patterns that emerge. There were good years for investors back in the Great Depression but it was still a Great Depression. And we still have threats to the economy. Treasury Secretary Timothy Giethner said today that fallout from the European debt crisis along with fears of Iran and higher oil prices posed the biggest threats to the U.S. economy.

"Europe is still facing a very difficult, very challenging period. They are likely to have weak growth. You have, obviously, the fear of Iran and oil prices, even though that is not hurting the economy today, people can still feel that in their pocketbook today," he said.

Yea, yea; if it's not one thing it's another, but still the market has rallied. This stock market rally, like so many others over the past three years, is a by-product of central bank money giveaways - most recently this year from the European Central Bank and Bank of Japan, and this follow QE1 and QE2 and Operation Twist by the Federal Reserve.

And when the central bankers throw money at the markets, the markets rally and when the free money dries up the green shoots wither and we have nasty corrections. And even though stocks have been moving higher we still haven't seen the sustainable recovery, the righteous circle where growth equates to confidence and confidence equates to jobs and jobs create money that is circulated through the economy and that equates to growth, etc. Yes, we've largely avoided disaster but that's not the same as recovery. And there is a nagging feeling that we're now dependent on this artificial stimulation, that the economy can't stand on its own without the intervention of the Fed.

About a year ago, Pimco, the giant bond fund talked about the possibility of years of persistently sub-par growth, stock market false starts and the constant need for new monetary stimuli. They called it the new normal. This long, Japan-style economic funk across the developed world is still the reality and the first quarter surge in stocks is now over and we have to be careful not to think we've entered a new period of sustainable recovery. This is not "business as usual". Markets have a tendency to move from despondency to euphoria and back again when little in economic reality has actually changed . Sentiment and reality are not the same thing.

How can we tell if we have a genuine rally? Is there anything that we can use for confirmation? Well, how about the disconnect between top rated government bond yields, such as the yield on the 10 year treasury note (which is still super low) and compare that to the surge in the stock market? What you see is the central bank intervention and artificial manipulation of the markets. In old-fashioned normal times, you might expect the bond yields to rise and fall with equity prices.

It's pretty simple really; when the economy is strong and we have economic growth, that lifts company profits and stock prices. And, in turn, that growth erodes spare capacity and generates price pressures. People have jobs, they earn money, they spend money, we have a more dollars chasing a limited number of goods and services and prices get pushed higher. And that prompts investors to demand higher bond yields to compensate for future inflation risks.

Look back at all of the significant stock rallies of the past 20 years and you'll see that as stocks moved higher, bond yields moved higher. Remember that bond yields move inverse to bond prices. And so we have the core principle of Modern Portfolio Theory and the whole idea behind diversification. When stocks go up, bonds go down, and when bonds go down we might expect stocks to go up; therefore if you stay diversified you can hedge against losses.

But this correlation, which we've seen in all "significant" equity rallies for the past 20 years, has broken down badly over the past 18 months. The Fed has been pumping cash into the Wall Street banks and the banks have been pumping cash into risky assets such as equities, but the Fed has simultaneously been buying bonds and with a big buyer like the Fed keeping bond prices artificially high, the yields can't get off the floor.

There has not yet been a wholesale shift to equities from the "safe-haven" and negative real yields of the shrinking pool of triple-A bonds. To be sure, some of that inertia is structural among pension funds and central bankers, but there is also basic concern the economy is far from repaired.

So is the rally in stocks a fake out or is the big bamboozle in bonds? The temptation is to view manipulated government borrowing rates as the bum steer. But repeated disappointments from the underlying economy and persistently high unemployment rates suggest the "new normal" scenario is still most compelling, leaving the stock market likely way ahead of itself again.

We did have a rally in bond yields last month and it got people excited for a while. Maybe bond yields were ready to soar. Fund managers actually cut bond holdings to a six-month low. Could it be the bond market was at last confirming the recovery flagged first by the rally in stocks? The 40 basis points jump in 10-year Treasury yields only returned rates back to October levels, so the excitement was probably overblown. And then Fed Chairman Bernanke warned about the economic outlook and the bond market took that to mean the Fed was looking at more bond buying, and prices firmed up and yields went back to their place on the floor, and people questioned whether the Federal Reserve really has faith in an economic recovery. And then the past couple of days confirmed the recovery is not genuine and sustainable. For all the trillions pumped into Wall Street over the past few years, we still haven't corrected the underlying problems, and without the support of the Federal Reserve, the economy feels all wobbly and weak. Maybe the central bank intervention made the markets overly dependent on free money, but the reality is that the new normal is not a sustainable, genuine recovery.

Sinclair Noe