As I stated in the Summer commentary, “‘the rapid appreciation of security values that we are witnessing today is completely and predictably…typical’” for the recovery periods following all major market panics. Just the removal of the fear from the unknown is generally enough to lead to a meaningful bounce in pricing. But as we discussed in February, sooner or later, the discussion must turn from one of emotion to debates of valuation and forecasts of business conditions. We are certainly moving into that part of the recovery cycle. At this point, much of the low hanging fruit of the rebound may have been picked. But their still may be some within reach.
Although confidence and clarity is beginning to build, we suspect this phenomenon to repeat itself for the next couple of quarters until the analyst community gets its sea-legs again. Q3 earnings season, although still in its first days at the time of this writing, appears to be confirming that notion. Further, as we get into Q4 and beyond, year over year comparisons are going to start to look very compelling for most companies. With the earnings wind still at our back, the next 1,000 point apple (or two) may not be out of reach.
I hate to repeat myself, repeat myself, repeat myself, but we’ve got to talk about inflation and the dollar again. The vocal minority of inflation hawks (including Warren Buffet and Bill Gross) that I mentioned last quarter is growing in numbers. I still believe that the Fed and the administration will do whatever they can to keep this from becoming a major issue until we’ve gotten through all the other major issues we have to deal with (the economy, unemployment, housing, commercial real estate etc.). The conspiracy theorists in me thinks they will manage to do so at least until healthcare reform and the mid-term elections are past us. But if global confidence continues to erode, this simply may be beyond their powers.
Lastly, I will offer up a point for discussion. I am not sure we’ve actually gotten their quite yet, but I think the rally in the credit markets might prove to have gotten ahead of itself. We are starting to price in better economic conditions and financial health than I believe we have a right to at this point in the cycle. The dramatic rally in this market in just eight months cannot be ignored. We have gone from 2400 basis points spreads over Treasuries to about 700 in its short period. At the same time, default rates are shooting higher with no signs of slowing down. Are we so sure that this economy is heading for a sustainable recover that we are willing to accept so little for our risk again?
Is risk fairly priced here? We can and should be asking ourselves that question about every investable capital market available…even Treasuries. At some point, the pendulum which got so far away from norms both before the crisis started and during itself depths might swing too far to the other side again. Better start asking yourself where your comfort level is. I’m not so sure how much low hanging fruit is left in the risk/reward orchard. Maybe it depends on your PIERspective.
Jim Scheinberg