What are the Equity Markets Smoking?

I’m torn between relief at watching my 403(b) improve and wondering why the stock markets appear so oblivious to reality at the moment.  Stock markets appear to be celebrating the loosened mark-to-market rules and only the Greater Ethos would know what else. (Perhaps Spring break and more Girls Gone Wild Videos in the offing?) During the 14 trading days prior to March 27th, the S&P 500 index jumped 21%.  That would be akin to the steepest rally since 1938.  At the same time, the corporate bond market saw 35 defaults.  Moody’s stated that number of defaults has not been seen in single month since the Great Depression.  The Economist (April 11, 2009), in the article Whistling in the Dark thinks Equity investors have been humming the Monty Python Classic.

As American companies begin the first-quarter earnings season, the news on that front is hardly encouraging either. Profits are forecast to be down by 37%, according to Bloomberg. That will be the seventh straight quarterly drop, the longest losing stretch since, yes, the Depression.

So what explains this dichotomy between share prices and fundamentals? Markets fell so far, so fast that they already reflected a lot of bad news. And prices rarely drop in a straight line. They often rebound as investors who have gone short (bet on falling prices) take profits. There were five rallies of 20% or more between 1930 and 1932, during the worst bear market in history.

So, who is right?  I’m going with the bond markets.  They usually have the inside track on what is going on with the companies themselves because they are, well, bond holders.  At least Equity Market Volatility is down and the markets appear ready to acknowledge bottom shortly.  This is better than the recent series of financial and economic variables that look more like the trails of lemmings over precipices than randomly varying series.  Still, the bond markets and most economists are somber because the real numbers still aren’t pointing to recovery despite what Bernanke and POTUS say recently about Green Shoots and Glimmers of Hope.

But David Rosenberg of Bank of America Merrill Lynch, one of the few Wall Street economists to predict the current recession, is sceptical. He points out that although the Institute of Supply Management’s index of American manufacturing has rebounded from 32.9 to 36, the latter figure is still the fourth worst in the last 27 years. Capital Economics, a consultancy, says its recovery index suggests the probability that the American recession has ended is less than 10%.

Other indicators also cast doubt on the idea of a sharp rebound. The Baltic Dry Index of freight rates is seen as a measure of global trade activity (although it is also affected by the supply of shipping). It bottomed in December, a staggering 94% below the May 2008 high. From that point, it more than trebled by early March, a sign of a rebound in activity. But it has since resumed falling and is down by around a third in the last four weeks. Nor is there any sign of a big pickup in commodity prices; the Dow Jones AIG index is above its recent low on March 2nd but is still less than half last July’s peak.

Read the rest of this entry »