Don't Get Carried Away Yet

06/18/2009 10:47 am EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, editor of Investment Quality Trends, says we need to see real signs of confidence before we can declare the recession and bear market over.

While the primary trend of the market remains down, market participants are decidedly more upbeat, and there is emerging evidence that consumer confidence is starting to rebound.

There are also positive signs that the credit markets are thawing in specific areas, such as the LIBOR rate. LIBOR (London InterBank Offered Rate) is the interest rate banks charge each other for one-month, three-month, six-month, and one-year loans. Since peaking in October, LIBOR rates have declined significantly, although they remain elevated compared to levels prior to the credit crisis.

While the interbank market shows signs of healing, the US mortgage market remains tight. Since April, the average rate [for a 30-year mortgage] has nudged higher in concert with rising rates on ten- and 30-year government bonds. With the spread between the 30-year mortgage rate and the three-month dollar LIBOR rate over 400 basis points (four percentage points), there is room for mortgage rates to move lower.

The bounce off the March lows at this point must be viewed as an overdue technical correction. For the rally to continue, investor and consumer confidence must show continued strength, meaning buying and spending. For the consumer to begin buying at the required levels, incomes will necessarily have to improve.

Once again, let’s have some perspective. The auto industry, as has much of manufacturing, suffered a major body blow. The financial services industry is reeling and even the health care industry is seeing layoffs. This begs the question, then, where will the job creation come from to replace these incomes? Without income replacement, consumer spending will necessarily be muted from past recoveries.

An up tick in investor and consumer confidence notwithstanding, the reality is there is an ongoing global recession. The economies of Germany, England, and Japan are still contracting significantly; Chinese exports are down almost half. If this wasn’t sufficiently disturbing, the European banks are in even worse shape than their US counterparts. To combat this recession, governments around the globe are running gargantuan deficits, which necessarily translates into trillions of dollars of debt that needs to be financed.

Taken together, all the above should be deflationary, [and] interest rates should be flat, if not outright declining. Interestingly, though, interest rates aren’t declining in the all-important ten- and 30-year government bond area.

What is the bond market saying? Hope and change, meet Mr. Market; trillion-dollar deficits as far as the eye can see just aren’t going to fly.

The above notwithstanding, there is opportunity in the stock market. Companies with transparent
business models, with clean balance sheets and clear evidence they can pay dividends and interest without question, that have received no government assistance, will survive this economic down cycle and prosper coming out. These are the companies that will reward you for years to come.

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