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Never Hurts To Have A Life Vest

Trading in the equity arena is getting back to normal, slowly, which is to say that investors are back to behaving semi-irrationally.

The S&P tacked on 0.4% today, while TYU0 declined 6/32nds and the 10y yield moved to 3.37%. But why did stocks rally?

Initial claims were approximately as-expected at 453,000 and remain in the range. ADP was weaker-than-expected at 55k; that may not matter since tomorrow's Payrolls data will be dominated by Census hires anyway. The Non-Manufacturing ISM at 55.4 was unchanged and right about where folks were expecting to see it.

Oh, and in the meantime, banks invested a record €320bln (nearly $400bln) in overnight deposits at the ECB. This means that European banks are even more wary of lending to each other than they were at the nadir of the FNMA/FHLMC/AIG/Lehman disasters. Meanwhile, G-20 finance ministers have decided to postpone the time when they will begin to withdraw stimulus from the global economy, because the banking/sovereign debt/credit crisis in Europe makes that plan seem a mite premature.

I don't think that equity investors seem to get the joke right now. There is a tide of bad things that is rising right now, and any of them might swamp the boat. Unlike in 2008, the number of tools available to avert a repeat (really, a continuation) of the banking crisis is significantly limited. One of those tools is pure monetization, which may be why inflation-linked bonds recovered somewhat today. The inflation curve has begun to look somewhat peculiar. The chart below shows the current spot inflation swaps curve as of today's close; the pale line shows the 1y forward inflation implied by those rates (that is, 1y inflation 1y forward, 1y inflation 2y forward, etc). Evidently, investors expect low inflation for the next year (1y swaps are at 0.50%), low inflation for the year after that (1.5% forward inflation), and then a rapid rise to around 3%, where it will level off. Curious.

Forward inflation (indicated by the pale line) is expected to rise sharply and then level off

I don't know whether it is that familiarity breeds contempt and we have become "familiar" with the crisis, but we are walking down a dangerous path and the stock market seems ridiculously sanguine.

Perhaps it is that people have been listening to all of these hearings where some windbag declares "we need to pass rules so that this can never happen again." Maybe investors believe that we are safer now; we have solved the problems and it will never happen again because this time, we are paying attention. But of course, "it" not only can happen again, it is absolutely guaranteed to do so eventually. Nothing that anyone can do can stop the natural rhythms of society and behavior. Even if the market is completely stopped, and the economy completely controlled, it cannot stop these rhythms - or have we forgotten already that the USSR experiment ended in a colossal failure?

Working to constrain these natural tendencies merely makes the ultimate break worse. Greenspan's quixotic quest to eliminate the downside of the business cycle served only to encourage investors to abandon their margins of safety, which are considered expensive if a disaster isn't going to strike. What made the break so bad is that almost every investor had an inadequate margin of safety. Have we learned any lesson? Today, we are told that a 0% yield for money is too low, that we need to "put money to work." A big chunk of my money is working to protect me, thank you very much. Around my portfolio, I do the earning and my investments are meant to protect me. I don't ask my investments to earn much...just be there when I need you.


Tomorrow, the monthly Employment report ought to be fun. The consensus estimate is for 525k new jobs, compared to 290k last month. Private payrolls are expected to add 180k (231k last month), with Census workers providing most of the rest. The private payrolls number seems high, considering the ADP data, doesn't it? Economists also see the Unemployment Rate falling to 9.8% from 9.9%.

I think the market's two-day rally, while not a huge run, makes it vulnerable to even an as-expected number because at the same time the geopolitical backdrop has been worsening. I would be very reluctant to carry heavy longs into the summer months knowing that (a) this Payrolls number is likely to be the best jobs data we see for a long time and (b) there are many other ways for things to go wrong from here, and not very many ways they can go very right. And neither equities nor bonds are priced with a margin of safety included. I am preparing to pull back into my shell.

I am not going to be writing a comment tomorrow...not because I will be stuck in my shell, but because I will be out of the office. Enjoy the weekend.


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