Equities: S&P 600 via 1100

Back on December 8th I noted that 'the probability of a very dramatic rally in equity markets of 20% in coming weeks is high and rising, taking the Dow over 10,000 again' and I stand by that view, implying up to 1100 on the S&P. The mountain of cash on the investment sidelines (about $8.8trn) earning a minimal return in Treasuries and money market funds as the Fed cudgels conservative, prudent savers and marches them up the risk curve, will get redeployed over coming weeks as confidence in the rally and recovery momentum grows.

I also suggested that long term energy exposure was very attractively priced, as the oil price had undershot to the downside unsustainably, and that view is now being vindicated by strong sector performance.

However, make no mistake, this bear rally which will run maybe 33-40% from the November lows will be a wonderful opportunity to raise cash or hedge exposure before a new panic arises by late spring or early summer, re-testing and quite possibly crashing through the recent 740 S&P low. We're entering Act 3 of this horror movie, and after a respite for dramatic effect, that's when things get really gory.

Not only will we see a huge spike in US corporate and municipal defaults through mid-year, rising geopolitical risks resulting from the politically destabilizing fallout from the economic slump, and a likely further fall in S&P 2009 earnings forecasts to $50 or below but we're in a bizarre and dangerous scenario where monetary policy has become divorced from money.

The Fed, rather than passively supporting the necessary cyclical de-leveraging process, is actively targeting asset prices, hence the massive increase in its balance sheet in recent months as it seeks to make non-liquid assets attractive to banks to get them to lend again.

Monetary policy is essentially focused on inflating America's way out of a smothering debt pile by any and all means possible; so far, US money supply has exploded, but the velocity of money i.e. its multiplier effect through the real economy via credit creation, has remained frozen.

The US monetary base (basically its currency in the hands of the public and the reserves in the banking system) has soared to $1.7 trillion, much of this due to commercial banks depositing reserves at the Fed, which seems like a copy of the Japanese strategy of boosting a ZIRP regime by kick-starting interbank lending, with each bank comforted by the certainty of their counterparty's massive excess reserves.

However, that Japanese plan only ultimately worked when banks finally disclosed the full extent of the toxic debt on their balance sheets, and that transparency is still lacking in the US and elsewhere. There are many dangers in this frantic monetary fire-fighting which I will discuss in future posts, notably losing the confidence of key foreign buyers in the Treasury market and dollar, despite current efforts to 'game' long-term yields down. There is a real risk of igniting serious inflation beyond 2010/11 if the monetary transmission mechanisms begin to normalize. Hedging against long-term inflation via hard asset exposure and TIPS is wise on this view. After the TARP debacle, US economic credibility this year is on the line as never before and any missteps will be cruelly punished by global investors. Enjoy the ride.

Comments

[bosun.j:]

Brace yourself!

Jan 07 06:18 AM

[Maxe Paul:]

I holehartedly agree, the fact that everyone leveraged and borrowed to the brink and now the Fed is borrowing to buy these peoples losses is very worrying going forward. I expect we will see new lows when this dead cat bounce finshes come April or there abouts.

Jan 07 06:31 AM

[gon4beer:]

Mr. Maher appears to be an Elliott Wave devotee, as am I-I agree 100% with his conclusions. The current rally should take us to ~ 10,500 on the Dow and then watch out!

Jan 07 08:33 AM

[sieraromero:]

the market will rise so that it can suck a good deal more of your money away. The market looks forward and prices accordingly, but it does not always do so correctly. The main economic pain and problems have not even been seen yet. States and counties and cities are all having great difficulties. the fed has kept our heads above water albeit only for a short time and that is only because of massive commitments. We are printing money so fast we have to outsource it to other countries as we can not keep up devauling our currency fast enough. People are piling back into the market because they want to recoup some of their losses and are still greedy, and though a little more concerned see the market as a way to make money. You my friends should be much, much more concerned at this point in time of PRESERVING YOUR ASSETS. This is just a big bear trap! Good Kuck to you alll!

Jan 07 08:40 AM

[sieraromero:]

Sorry--Good Luck to you all!

Jan 07 09:31 AM

[DaveW:]

Agreed, in a major downtrend what goes up, must come down. Good luck out there!

Jan 07 10:32 AM