Posts Tagged ‘bond’

Divergent sentiment

Friday, October 13th, 2006

Today, we looked at and saw something quite amusing. One set of headlines cheered in jubilation: ?Earnings driving the Dow? and ?Michael Farr says investors ‘are thinking positive’.? Another headline wallowed in worry: ?Manufacturers see gloom ahead.?

Is the US economy slowing down and threatening to roll over into recession? Remember, it was not long ago that the fall in manufacturing index prompted the stock market sentiment to turn negative. Now, the market merely shrugged off this report. The housing boom had already collapsed and threatened to cut down US consumer spending, which made up 70% of the US economy.

On the other hand, is the US economy going to power ahead as what the stock market is feeling it would right now? Perhaps the rebound in consumer confidence and the fall in oil prices will help the economy get into a perfect ?soft-landing??

Now, let?s get back to the basics. Make no mistake: the US economy is indeed slowing. The question is, whether this slowdown will result in a ?soft-landing? or recession (or worse still, a depression). Currently, the US economy is at an inflection point. The stock market seems to believe that after this inflection point, the US economy will not get too bad, maybe even mounting ahead. The bond market, on the other hand, believes the opposite. Who is right?

We believe that neither is right. As what we heard from Marc Faber?s (a famous contrarian investor) recent presentation, you can make the Dow Jones climb as high as you want as long as you print enough money. When excess money is being printed, company earnings will definitely grow in nominal terms, which will propel stock prices even higher. But that doesn?t mean that the economy?s production has increased. In other words, real GDP growth will not necessarily grow as much as the growth in money supply. Put it simply, the Dow Jones will rise merely due to inflation.

So, the stock market is wrong, not because the stock prices rise due to economic growth. They rise due to monetary inflation (printing of money). To illustrate this point further, over the past several years, the Dow Jones might be higher in nominal terms, but in real (inflation-adjusted) term, it had fallen.

The bond market is wrong, not because interest rates will be cut due to a recession. On the contrary, this coming recession will be accompanied by excess monetary inflation, which means nominal interest rates have to rise.

But be note that – the above-mentioned scenario will take time to work out. It will not happen overnight. Therefore, time is on your side as you fortify your financial well-being from the coming storm. In the meantime, expect more volatility.