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Rowing Against the Current: Scenes From a Bear Rally

In spite of a continuous stream of data indicating that the coming decade is going to be one of the worst in terms of unemployment, commodity oversupply, and capacity excesses, the bear rally does not seem to have any desire of losing its momentum just yet. The chorus of voices speaking of bubbles and overextended markets does not seem to unnerve bullish traders very much, as the main indicators of stress, such as LIBOR rates, the VIX, junk bonds spreads, and trends in carry trade pairs all remain reasonably healthy. On the other hand, while these short-term indicators of financial market sentiment remain more or less bullish, long-term indicators of economic growth continue to emit very negative signals. Fixed investment and bank lending are still at very subdued levels, with little sign of a credible revival. Add to that the long-term effects of new regulation being imposed on every sector economy, and it is hard to imagine that the hectic days of the last decade will ever return in the day same form again.

The markets are for now enjoying the fruits of government intervention, and the natural rebound in activity as inventory liquidation draws to a close. And yet, sizable and severe as the liquidation phase was, outside of the financial markets, and a few industries where government action is distorting prices (such as in copper and iron markets), there is very little that can be shown as actual improvement. The cost of credit is falling, yet there is no sign of a meaningful revival in demand for new borrowing, as both the consumer and corporations remain wary of the future. Meanwhile, the U.S. retail sector is in complete disarray, as the U.S. consumer begins to imitate its cautious peers in other developed nations. International trade is likely to end up contracting this year as well, in spite of government intervention, and large export credits offered to businesses in many different nations. Any significant improvement is limited to the financial sector so far, but how much of that is created by cooked books, and how much is caused by meaningful repair of past mistakes, and preparation for future losses?

Not much, apparently. According to analysts at Capital Management LLC, as reported by Bloomberg, the decision of the Financial Accounting Standards Board in April to relax fair-value accounting rules has had a significant role in fuelling the sizable rally in financial shares. The rationale behind that decision was that allowing firms to benefit from less strict rules would somehow forestall the race-to-the-bottom in the asset markets. So far the attempt appears to be a success. Yet at what cost? Everyone knows that the cause of Japan’s slump in the 1990’s was this very same laxness in accounting standards that created zombies out of banks, and that the government is taking the same approach, and discarding the most basic tenets of capitalism can hardly be a justification for the general enthusiasm ruling in the markets these days.

At the end of the day, the simple fact is that no amount of financial wizardry will move a nation out of bankruptcy unless the fact of bankruptcy is recognized. The bright minds at the Federal Reserve and the Treasury are working day and night to convince us all that all is well and that attitude is the basis and cause of their errors. In due time, we’ll see if we can eliminate problems by just claiming that they don’t exist, but historical evidence does not justify much enthusiasm for this approach, at least as far as we are concerned.