Recent events suggest the risk aversion that had dominated markets in recent weeks has reversed.
By PINCHAS LANDAU
Wednesday was a very big day on almost all the financial markets. So big that it very likely ushered in the next leg up of the rally underway across the globe since March (in equities, and earlier in some markets).
A brief and necessarily partial list of "participants" in Wednesday's party includes the equity markets, which surged everywhere by several percent; government bonds, which fell sharply as investors moved from "safe havens" to riskier investments; corporate bonds and those of emerging-market countries, which were the beneficiaries of the move from safe to riskier investments and so rose; and, in a parallel development in the currency markets, the US dollar and Japanese yen, which serve as (relatively) safe havens and therefore fell, while the Canadian and Australian dollars and other "commodity currencies" rose; and precious metals, which surged as they often do when the dollar falls (although they are also supposed to be safe havens - go figure).
All this suggests that the risk aversion that had dominated markets in recent weeks - and had been exemplified in the sharp rise in the yen, discussed here last week - has reversed. In terms of the wider picture, it means that the rally is back on track, and fears of a longer or more protracted pullback from the highs reached in June can be set aside.
The first target for the renewed rally is, therefore, to regain and surpass those recent highs. Then the markets can resume their recovery and claw back more of the hefty losses they incurred between late 2007 and early 2009. Many analysts view the 1,000 mark for the S&P 500 index and the 10,000 level for the Dow Jones Industrial Average as obvious and inviting targets for this next leg up, and there seems no reason they should not be achieved during the summer.
Thus far, there is little disagreement between the various schools of thought on the markets, just as there is a wide consensus that the positive economic data of the second quarter should continue into the third at least, and perhaps the fourth quarter, too. But at some point in the not-too-distant future there lies a very dramatic parting of the ways.
The optimistic camp, who are actually a minority among serious and/or independent analysts, believe that the global and US economies are in the preliminary stages of a recovery from a severe recession that has already lasted 18 months and is thus both longer and far harsher than the average postwar recession. Corporate profits, too, will bottom and rebound, so that share prices will have justification to continue rising. Indeed, at least some in this camp believe that we are in the foothills of a new bull market, destined to run for years and scale previously unimagined heights.
The majority, however, do not believe the global economy is going anywhere very fast, or anytime soon. The markets are overdoing the good news, just as they exaggerated the bad news earlier this year, according to this view. The prospect is for a prolonged period of low growth, in which sluggish consumer demand, rising taxes and excess capacity will undermine profitability.
This distinctly un-rosy outlook means that there is nothing to get terribly excited about in any of the markets: share prices are not going to soar, bond prices are not going to crash, there will be no deflation, but no inflation to speak of either; the world will not run out of oil or other commodities, and the Chinese won't buy up Africa and other resource-rich continents. Everyone can calm down and lose their illusions, whether of riches or crashes. By implication, therefore, this view sees the top of the coming rally as a good opportunity to take profits, if they exist, or to sell and realize the reduced losses left from the crash - because, again, we aren't going anywhere for the next few years.
The other minority opinion sees the whole rally as an interlude between two rounds of disaster, with the second expected by them to be at least as bad, if not worse, than the first: both in terms of the size and "quality" of its corporate casualty list of bankruptcies, and in terms of the size and speed of the market moves it will generate, especially the falls in equity markets. Needless to say, therefore, this school views the current rally as the last and best opportunity to jump ship and abandon the equity and corporate-bond markets. Anything less is simply equivalent to rearranging the deck chairs on the Titanic.
If Wednesday's surge is indeed the liftoff for the next leg of the rally, it suggests that investors have a few weeks left to decide which view to adopt and, if they accept the majority gloomy-to-disastrous view, to position themselves accordingly.
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