Mid-Summer Stock Rally Sending False Signals

Stock markets around the world have rallied strongly since the start of July, snapping losing streaks for the year, and stepping back from the edge of the cliff after marching there to the beat of the Greek debt crisis.

The Chinese stock market for instance, as good an indicator as any given its export based economy, has rebounded strongly after hitting a 15-month low at the end of June when it had plunged by nearly 30 percent.

The benchmark Shanghai Composite Index rallied 11 percent in July, the biggest monthly gain in a year, on speculation the government will increase investment and domestic spending to counter an obviously slowing economy.

China’s Federation of Logistics and Purchasing release of July statistics showed the manufacturing sector growing at the slowest pace in 17 months, as the official Purchasing Managers' Index fell to 51.2 from 52.1 in June.

Inflation has also been a problem in China as well as the other BRIC (Brazil, Russia, India & China) countries. The Chinese government has increased bank reserve requirements three times this year in order to counteract the inflationary trend and to arrest asset bubbles particularly in the real estate sector.

The question then is what does all this mean for the markets going forward?

From our perspective, these rallies are serving up false signals.

For one, the markets were due for a correction to the upside following major breaks to the downside from their April highs. Markets do not move in straight lines and this summer’s rallies are no exception.

But more importantly, 10-year treasury yields from around the world are pointing to continued uncertainty if not outright trouble around the corner.

German, French and US rates are all under 3 per cent. Japan is at just slightly over 1 per cent. These are hardly the types of returns that would signal to us the return of sustainable growth and expanding economies.

What we have here is a confluence of atypical factors skewing the overall picture. The effects of the 2009 quantitative easing (QE1) from around the world spilled into the world’s producing countries, such as China, stoking not only growth but also inflation. That is now starting to wear off, as is evidenced by China’s manufacturing slowdown.

Short-term speculation that growth will return should government step on the accelerator is just that: speculation.

The truth of the matter is that the hundreds of billions of QE1, as it is known, accomplished very little here in the US when looking at the unemployment rate.

All it did do in our opinion was create an inventory buildup boom in Asia and elsewhere based on artificial demand. The effect of stockpiles of finished products with nowhere to go will, sooner or later, get priced into the stock market.

In addition, governments in Europe and elsewhere have come to terms with deficit woes and are tightening the budgetary screws, so to speak. The G20 failed to agree on a coordinated effort to continue to provide a government backstop. Germany and much of Europe have started to see things one-way, the US another. There is no uniformity.

The bond market historically has been a better forecasting tool than the stock market, and while the two markets are currently sending opposing signals, we believe the bond market has seen right through QE1 for the farce that it was. Hence it is raising red flags.

The stock market on the other hand has become a treacherous place made even more so of late by day-traders as well as the hundreds of hedge, quant and high-frequency trading outfits looking to outwit each other for fractions. Anybody with a laptop and a discount broker account can have a say in the stock market these days - this is typically not the case in the bond market.

The stock market therefore can continue to go up until, one day, it doesn’t. That might sound like too simple an explanation but that, in a nutshell, is what’s become of old reliable: in my opinion the efficient discounting mechanism, that so many believed was the stock market, is no more. Some would argue it never really was.

Investors should therefore appreciate and respect the bond market’s current message.

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