U.S. Markets in Early Recession Mode; Japan Already Discounting One

Financial markets are clearly in an early recession mode, with commodities like oil and gold now 25%~20% above mid-June 2006 highs, while equities are clearly struggling, particularly Japan equities. Long bond yields in the US, Japan and around the world are clearly in decline.

Hedge funds and pension funds are switched into commodities for alpha as well as downside equity risk hedging. With oil prices now at $100/bbl for only the third time since the 1800s, the 64,000 dollar question now is, how far can this commodities bubble go?

According to the Peak Oil scenario, higher oil prices are here to stay; i.e., there will be no bust as there was historically that takes oil prices back to low one-digit levels. The growing global warming movement also argues against pell-mell primary energy resource development at the expense of the environment.

As was the case during the S&L crisis in the late 1980s, continued easing by the Fed and other central banks may not have any appreciable impact for the foreseeable future, as the issue is solvency, not liquidity.

Yet the S&P 500 remains relatively well supported, unlike the Nikkei 225 which has already discounted a recession in losing nearly 20% over the past 12 months. This implies to us there is potentially more downside in the US stock market than in Japanese equities, especially if commodity markets continue to run.

There is no doubt that the growing influence of sovereign wealth funds are a stabilizing factor for global equities, without which stock prices may have well already crashed. But as Alan Greenspan mentioned in his new book, market sentiment rarely moves smoothly from optimism to pessimism, but is more like a dam breaking. When positive sentiment breaks, the torrent carries away whatever shreds of confidence remain, leaving only fear.

In Japan, this fear is creating good long-term value bargains that we believe will again draw increasing amounts of foreign value investor funds. Not enough to create strong market performance, mind you, but enough for discerning investors to eke out positive alpha returns.

click to enlarge

Comments

[iamrodent]

The solvency versus liquidity argument is so critical that some people must be afraid to talk about it for some reason. All the rate cuts in the world will not do a thing to head off massive mortgage and credit card defaults; all of the liquidity options executed by the Fed are being used by financial institutions to build a cash position, not to lend money responsibly to create economic growth. Back in August the ECB in one day injected 267b Euros (then $300b US) into the banking system. If my memory of the US code is correct, this would be an amount of money equal to the US circulating cash supply as prescribed by Congress being dumped into the market in one day; almost beyond comprehension in this context. Maybe this is why Trichet hasn't done rate cuts? August may also be what can be called the starting point of the recession. Why? The government's own jobs report, which grossly distorts private sector job growth by adding health and education to private sector jobs when these jobs are either on public payrolls and/or paid for by tax dollars. The truth is as follows, in thousands: June, 0; July, 59; August, -32; Sept., 16; Oct., 61; Nov., 58; Dec. -57. October and November were also revised downward. This is an average of 15k private sector jobs created per month.

[the_pig_man]

Looks like Japan small companies have effectively
crashed and sell mostly for below book value. Since
they are not dependent on exports, are they buys?

[DarrelWhiten]

As Japan's small caps usually show sustained rallies at the beginning of economic recoveries, they could be dead in the water until the current storm passes even if the downside is now limited by break-up values.