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Are stock markets heading for a breather? Euphoria surrounding Asian equities have cooled down considerably over the past week, prompted by profit taking amid concerns that stock valuations ramped up too fast and are inconsistent with underlying earnings.

More importantly, China’s intent to rein in the flood of new bank loans to the tune of Rmb7,370bn (more than twice the amount lent last year), many of which appear to be speculative in nature.

Recently, Chinese regulators ordered banks to ensure the record number of new loans are funnelled into the real economy and not to inflate asset bubbles in the equity or real estate markets. Banks must now monitor how their loans are spent and that has temporarily stopped the red-hot Shanghai stock market in its track.

Over in Europe, economic conditions are looking more promising but they are not out of the woods yet. German industrial production fell 0.1% as compared to an estimated increase of 0.5%. The UK economy has a smaller contraction for the second quarter but weaknesses persist in the financial and business services sector.

The Bank of England’s decision to increase the size of its asset purchase program shows that the UK financial system is still suffering from deleveraging and a deluge of toxic assets. Compared to leading US financial institutions which are sheltered by the Federal Reserve, European banks have more dark days ahead.

Don’t expect them to report blow-out earnings on the scale of Goldman Sachs (NYSE:GS). In fact, Royal Bank of Scotland (NYSE:RBS) just reported huge losses of 1.04 billion pounds, despite revenue increasing 58%. The loss was mainly due to an increase in bad debts to 7.5 billion pounds.

Meanwhile, the European Central Bank has provided about $600 billion financing to the banking system as it foresees a credit crunch in the fall and may be taking advantage of a relatively calm period in the market to create a buffer against a possible funding shortfall.

U.S. Outlook

As for the US stock market, it closed on a high last week after rebounding from early weaknesses, thanks to an optimistic report by the US Labor Department. The unemployment rate slipped lower to 9.4% from the forecasted 9.6%. Nevertheless, jobless claims increased which means jobs remain scarce and businesses are not expanding as fast as the heady stock market suggests.

The better than expected US jobs data is likely to reinforce the view that the economy is stabilizing after a generational financial crisis. Some economists have even suggested that the economy will rebound strongly in the third quarter, with a surge in vehicle production. However, any fledging recovery could still be threatened by strong economic headwinds.

The latest Federal Reserve credit report revealed a drop for the fifth straight month. Banks’ restrictive lending, unemployment, stagnant wages and falling home values resulted in a widespread reluctance of households to borrow money for spending. With debt weary US consumers (which accounts for 70% US GDP), the US economy and export markets will not be in a hurry to rush into a V-shaped recovery even as the recession eases.

Recovery: Real or a Mirage?

It is hard to say if the US economy has recovered or just a mirage caused by Quantitative Easing but there is little doubt green shoots have come at the expense of the federal balance sheet which was compromised by unprecedented debt. The US government is determined to keep its financial system from failing, ease the credit crunch and prevent deflation. It has turned to printing money furiously which has tarnished much of the US dollar’s safe haven status.

The massive amount of money created out of thin air has caused consternation amongst foreign creditors and investors. Their lack of participation in US Treasury auctions will result in higher cost of borrowing (higher yields and lower prices of bonds), and that leaves the Fed with little choice but to monetize its own debt, with further dire implications on the US dollar.

Chinese Stimulus

In the past, China depended heavily on exports to the US and has a keen interest to prevent its currency from appreciating. They do so by purchasing and propping the price of US denominated assets.

But with America in doldrums, China has to implement its own stimulus package to offset the weak export market and maintain an 8% growth through public infrastructure spending, investment and consumer spending. As strong inflationary pressures build up, a stronger yuan may be a more useful weapon for the central bank. There is little incentive to continue bolstering the US dollar.

As the US dollar is at risk of losing its function as a store of value, investors may consider a diversified approach to something as mundane as cash. Gold continues to be true money that cannot be printed and a prized asset for those who lose their confidence in fiat currencies.

I believe gold is an important component in our portfolio mainly for insurance against inflation rather than capital gain. Stocks have got ahead of themselves and most coporate earnings are barely satisfactory. Investing in the stock market is skewed against retail investors and one has to be avoid excessive leverage to chase profits as market direction can turn on a dime.

Goldman Sachs and Front-running

Retail investors are helpless against financial institutions equipped with state of the art technology and algorithms which allow them to see what cards market participants are playing in split seconds. This will allow the big banks to front run customers and skim profits from every trade.

Goldman Sachs (GS) just brought criminal charges against one of their programmers for stealing a software program that allowed them to front-run their own customers. In their criminal complaint, they said the software would allow someone to manipulate the stock market.

Now, isn’t this admission very disturbing? If you are considering cashing out your retirement nest, maxing out your margin account or taking out home equity loans to invest in the stock market, you could get burned very badly.

More Dark Clouds

There are other dark clouds over the horizon which do not square with the possibility of a V-shaped economic recovery. CIT (NYSE:CIT) , the troubled commercial lender that serves small and midsize retailers and manufacturers, is still struggling to survive and if it does file for bankruptcy, the impact on US businesses could be severe.

Confidence could take a further hit as California IOUs don’t seem to be working very well. The state may have a budget now but any hopes of redeeming the IOUs is far away. Already, some contractors have sued California for paying in IOUs. According to William M. Audet, lawyer for the plaintiff, “The state is forcing people to accept these pieces of paper and pay taxes on them. Small businesses are closing, and more will close by the time the state redeems these warrants.”

Also, problems in the financial system remain hidden. Derivatives, all $600 trillion of them, show that there are far more debt in the world than assets to cover it. To reduce them into something more manageable could wreck havoc once again on financial markets. While derivatives are zero-sum games which does not benefit the economy in terms of tangible production, they do serve a purpose in risk management.

Derivatives are necessary for businesses who need to hedge against risks like interest rates or foreign exchange losses but there are investors who indulge in such contracts for the purpose which can only be best described as gambling. Such investors play with money they don’t have and since most derivatives are written over the counter without checks and supervision, you have to depend on the good faith and credit of the counterparty which in some cases, contain some dubious risk profiles.

It is clear that the unraveling of derivatives will have severe implications on the stock market but nobody seems interested in implementing a framework to safely regulate such activities. Maybe we should just wait for the whole thing to blow up before taking action.

Another factor which will impact economic recovery is rising crude oil prices. As the global economy recovers, demand for crude oil will increase furiously even as supply is depleted irreversibly. Crude oil may face downward pressure as rumors surface that the Federal Trade Commission will impose fines on market abuse.

This will prevent excess speculation but the fact remains that we are approaching or have passed peak oil. Market forces will drive oil prices up beyond the average consumers’ affordability levels and eat into the profits of businesses and discretionary income of consumers.

As for residential properties, they are enjoying a new lease of life (long queues, blank checks and scuffles in showrooms), I doubt they are sustainable. The stimulatory effects and loose monetary policies have propped up prices for properties but they are not accurate reflections of demand, affordability or a lack of good properties. In fact, the supply chain is strong as there are many deferred projects waiting to be launched.

In conclusion, I am keeping my fingers crossed on a sustainable recovery in the economy. The rampant bullishness was able to cover some horrific earnings but the likelihood of another crash is quite high. In fact, I would not be surprised to see stocks drastically correct by October.

Source: Don’t Bet on a V-Shaped Economic Recovery