Market Outlook: Expect Volatility and a Shallow Correction

What a difference three months makes. From the early March lows through June 1, broad stock indexes are up between 40% (S&P 500) and 65% (MSCI Emerging Markets). The price of oil has doubled from its first quarter bottom, and yields on junk bond indexes have nearly been cut in half. The predominant worry has shifted from a debt deflation trap to a government-sponsored inflation problem. Investors have steadily renounced their extreme risk aversion and demand for safety.

Equity, commodity, and credit markets are unequivocally acting as though the credit crisis is over and a new global economic recovery is on the way. Apart from the typically strong initial rebound from a bear market bottom, two factors would seem to account for the extraordinary shift in the investment landscape over the past three months. First, the fear of financial and economic apocalypse was more intense than the vast majority of investors had ever before experienced.

Since markets are a reflection of mass psychology, this led to a situation where sentiment became so negative and investment postures so defensive that risk assets had nowhere to go but up. Second, we have the exceptional circumstance of the greatest fiscal and monetary stimulus in history, and it is certainly working to revive global economic activity and asset prices. Ben Bernanke famously said in 2002 that deflation is always reversible under a fiat (paper based) money system. The surprise is not that he has been proven right, but that so many rejected his premise in the dark days of February and early March.

Few observers today doubt the ability of the Treasury and Fed to create inflation by widening the federal deficit and expanding the monetary base in such an unprecedented fashion. Now that we have had the powerful thrust off the lows, what happens next? Risk assets, especially in “high beta” asset classes like emerging markets and natural resources stocks, look very overbought. But a lot of investors – professional and nonprofessional alike – are still sitting on too much cash, and the pressure to get money invested in an environment where cash pays next to nothing, asset prices are moving up, and inflation expectations are rising, is intense. While this bull market – only three months old -should be given the benefit of the doubt, the risk/return profile of stocks over the next couple of months appear neutral at best, given how much we have rallied from the lows.

Within weeks, a meaningful correction will likely commence in stocks and other correlated markets, such as commodities, foreign currencies, higher risk bonds, etc. But the correction will probably be fairly shallow, retracing perhaps one-third of the gains since early March. For investors who are holding too much cash relative to their asset allocation targets, a patient, methodical approach to new buying should be employed, especially in asset classes that have run up the most. It is still a very uncertain world, and there will undoubtedly be plenty of volatility in the months ahead, as opposed to the nearly straight line up that has occurred thus far.

Emerging Markets Leading the Recovery
In the wake of the financial crisis, the “decoupling” theory – that emerging markets could continue to grow with developed economies in the grip of severe recession - was dismissed. Now, with (1) the MSCI Emerging Markets Index up an impressive 38% year-to-date, versus single-digit returns for the S&P 500 and the MSCI EAFE Index (foreign developed markets), and (2) certain emerging stock markets (i.e. China) back to levels prior to the collapse of Wall Street finance last September, the “decoupling” theory is back in vogue. There is an obvious element of truth to the theory, given the more favorable growth and demographic characteristics of key emerging markets, but clearly these economies are intertwined with the global economy, including the developed markets that still comprise a majority of global GDP. The recent strength of their stock markets suggests that the global economy is recovering.

Corporate Bond Spreads Continue to Normalize
Equity and commodity markets have recently confirmed that the depression is over, but credit markets have shown steady improvement since the fourth quarter of 2008, when the Fed began to apply its unprecedented support measures. Short-term commercial paper and inter-bank lending markets were the first to recover. Three-month U.S. dollar LIBOR (the inter-bank lending rate) is at a post-crisis low of 0.65%, after having been as high as 4.8% last October.

Corporate borrowing rates have declined steadily since late 2008, when the yields on corporate bonds rated Baa (the lower end of investment grade) implied default rates worse than those of the Great Depression! In the past six months, the spread between long-term Treasuries and long-term, Baa-rated corporate bonds has narrowed from over 5.5% to 3.5% (see chart below), a level that is more typical of a merely recessionary environment, rather than a depression. Municipal bond yields have shown a similar improvement, and are back to more normal relationships to federal government bond yields.

Comments

[jgbooker:]

Indeed I would expect a shallow dip this summer, followed by an almost complete recovery. The bear isn't done yet though. I feel a healthy dip coming this fall. I also believe the outlook one year out is exceptionally good (regarding equities).

Jun 11 08:35 AM

[CLH:]

Yes I agree with you. The panic last year produced some incredible bargains. Those who are waiting now because they are still frightened will regret as they buy in at higher prices.

Jun 11 05:41 PM