Investor Risk Appetite at New Highs – While the Markets Are Going Nowhere
By Frank Suess - November 05, 2009

I started reading Too Big to Fail by Andrew Sorkin over the weekend. As I currently follow the developments surrounding the CIT Group, I find the book helping me to vividly imagine the hustle-and-bustle behind the scenes. The ‘captains´ on Wall Street, in Washington D.C., and everywhere else are certainly concerned and you can be sure that the phone lines are running hot.

In America, and most other western nations alike, withdrawing from the current mode of government bailouts and spending will be difficult. The bankruptcy of CIT should drive this point home decisively.

Another USD 2.3 Billion of taxpayer money has gone into CIT. So far this year over 100 American banks have gone belly-up. There is more to come. So, how can government withdraw now?!?! The short answer: they won´t. A deflation-inflation sequence of events ahead is becoming more and more probable.

Australia and Norway – the rare exceptions

The only thing that continues to postpone the next phase of this bear market and financial crisis is the high level of liquidity and the low levels of interest rates. Today, they are more at variance with economic reality than at any time in history.

The grotesquely low interest rates worldwide have allowed governments, even deeply indebted governments, to go on spending and stimulating without hugely increasing the cost of servicing their existing levels of debt.

Despite recent investor exhuberance and the proclaimed recovery underway, so far, Australia and Norway are the rare exceptions of countries that in fact raised their interest rates.

The Australians just raised their rates a second time, after the first increase on October 6th. Back then, the world jubilated: a first clear signal that things were turning around. Buttressed by Chinese commodity demand and by years of government budget surpluses (until 2008-09), the Aussie economy had not seen a single quarter of ‘negative economic growth´ thus far in the global financial crisis (GFC). On October 28th, the Reserve Bank of Norway announced it was raising official rates by 0.25 percent, from 1.25 to 1.50.

However, Norway and Australia are the rare exceptions to the rule. Based on their commodity-based economies, they are in a special position that will not be easily copied by others.

The discrepancy of sentiment and fundamentals continues to warrant restraint

After their extreme distaste for risk last spring, investors rapidly regained their appetite. The big upward mood swing we´ve seen since March, reflective here by the following UBS equity-risk-appetite chart, is at rare height. How could market sentiment travel from despair to the boldness in just seven months?

UBS Chart

To any experienced investor, this kind of behavior should send alarms sounding off. To us, the underlying fundamentals never have appeared to justify the size of this extended (bear market) rally. Also, volume was notable for its absence in this rally. Yet, the market has gone far beyond our expectations, while our patience and resolve is being severely tested.

Two technicals may have played a role in keeping the market going. The first was trend. Prices were reaching higher highs and higher lows despite low volume. Anyone who simply followed the market´s lead did well. The second factor was breadth. Indicators such as the advance-decline lines — which keep a running tally of stocks going up, minus stocks going down, each day — were pointing higher.

But now, both of these factors have been reversed. The rising trends in the major market indexes have been broken to the downside, and industry group after industry group is now rolling over, including banks, transportation and apparel stocks.

Stock markets have run into a ceiling…so what´s next?

Since August, most markets have done very little. The DJ 30 broke through the 10000 level to get to 10112. Now things are going the other way. The stock markets´ astounding run from its March lows appears to have finally run into a real ceiling. After out-pacing most bear-market rallies over the past century, the market appears toppish.

Admittedly, previous bouts of selling in August and September also gave indications that a top was reached. We´ve been going into defensive mode in our portfolio management repeatedly, and repeatedly it was too soon. Bob Prechter, in his publication on October 30th, said it best: "Prolonged and leisurely, market tops force traders to learn a difficult yet essential skill: patience. Indeed, stocks sorely tested our own last month."

In any case, many old problems are getting worst and many hidden ones are coming out for another round. Currently, it all looks like a market top and a bumpy ride ahead. I recommend you fasten your seatbelt.

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