Market Overview, May 2010

Is the Great Recession really over? Warren Buffett seems to think so. And across the markets, it would appear that investors agree. Since hitting bottom just a little over one year ago, the S&P 500 has soared 65%. Retail sales are up and credit card delinquencies down.
Things are going so p0z (positive), I hear, that the Fed thinks it’s safe to stop buying dodgy mortgages and unshackle the Invisible Hand of the Market. Happy days it seems are here again.

And if you believe all that, then I’ve got some prime swampland in Florida to sell you. Also, a nice bridge with a tasty view of the Singapore Flyer – and perhaps, as we’ll see in a moment, a golden opportunity for timber investment on Mars.
As the Dow flirts with 11,000, investors are ecstatic at just how well the economy is rebounding. We haven’t “fixed the banks” or regulated the derivatives market that got us into this mess. And while consumer debt is down, that’s mainly because a lot of the debtors have defaulted on their loans, and the banks have written off the losses.
In short, there’s good news and bad news aplenty. So why are investors seeing only the former?
I’ll answer that question in the form of a parable. Once upon a time (January 2010, to be precise), NASA sent a satellite to Mars and began taking snapshots of the Martian surface.
If you’re a proponent of “life in outer space,” or just a Trekkie, chances are good that you see here what a lot of people thought they saw – 164-foot tall pine trees growing in the Martian desert. Positive proof of life on Mars.
Problem is … that’s not what the photo shows at all.
What it shows is: dark basaltic sand pushed to the surface of sand dunes by sun-heated solid carbon dioxide ice. As the dark sand rises to the light, sandy surface, it slips down the frozen dune (think nearly horizontal movement as opposed to vertical).
It’s a simple trick of perspective that this looks like a tree “growing up,” as opposed to sand sliding down. So … so much for life on Mars.
Of course, searching for life on Mars is a lot like searching for optimism in the market. Good news is what we want to see. So if the facts can be interpreted to reveal it, good news is what we do see.
In the language of psychology, we’re all “biased” toward seeing the facts that confirm our hopes. But while it’s a familiar phenomenon, and entirely understandable, that doesn’t mean investors are right to be seeing a recovery here – or that it’s safe to assume there is one.
Which brings us to …
Greek sovereign debt.
You’ve probably read and heard now that the greatest threat to the financial system today is “too much debt”.
If you believe that to be the case, then the European bailout appears to be no solution at all to the sovereign debt crisis because all the bailout does is to ladle even more debt onto the system.
Far from a solution, the Greece bailout actually exacerbates the problem.
There’s another view, though, which is that there is nothing inherently wrong with “too much” debt. The problem, if anything, is that as with any bubble in any asset category, debt is not appropriately priced the inherent risks associated with owning it.
For instance, it is not irrational to lend money to someone who is unlikely to repay the loan, provided you charge a high enough risk premium and hold enough other performing loans to offset the loss you expect to take on your risky loan. The crucial thing is that the lender must accurately price the risk, and prudently hedge it.
So let’s get back to European bailout package.
The package is designed to do one thing only: buy time. The thought is that because capital markets move faster than political reform, if Greece, and other troubled nations, have time to get their affairs in order, then perhaps they can get into a better position to repay their loans. That, in turn, will lower their borrowing costs. And the lower those borrowing costs, the better these nations will be positioned to repay their loans.
Which, in turn, lowers borrowing costs yet again. And so on.
What’s the exit strategy, then?
Your choices: Ironically, the solution will come once investors roll out of risk-free assets and start gaining more of an appetite for the risky stuff – equities and similar assets.
As we see that, the yield on US Treasuries will rise, lifting yields on all debt, only the increased risk appetite on the part of investors will lower the spreads.
Sounds like a rising tide will lift all ships but as with everything in life, you give something up for everything you gain. I’d go with the theory that we’ll all pay for this with higher rates of inflation and lower real value for most forms of currencies, to boot.
Higher inflation, or crash the entire financial system?
It’s a bit like asking whether you’d rather get slowly nibbled to death by Martian termites or get run over by a charging elephant. It’s a simple trick of perspective.

David Francis