The Rally Continues!

Well, I went on vacation and that market made a fool out of me while my back was turned!

Far from the rally running out of steam, as I predicted (here and here) the rally merely paused, then continued steeply upward, revitalizing the talk of recovery and green shoots.

Gold has gone back to tracking the market, and has also done well, as has oil. This makes me wonder if the surging stock market isn't really an early sign of inflation. This is what can happen in financial markets - they act as a canary in a coal mine, sending off inflationary signals well before consumer prices are affected. But these signals are hard to read. We generally think a rising market is good, and it carries us along in a bullish daze. Even my phrase "done well" to indicate "rising price" is a sign of the positive spin we put on it.

But I wonder what the market is up to. All that money the Fed created has to go somewhere. A lot of money is still on the sidelines, waiting to get back in. Barron's asked recently, should you get in or get out? Could this be the time that the Dow chooses to get back above 10k, even claim 11k?

I do not believe that the worst is over. The economic restructuring that is inevitable has barely begun. But a rising market has a way of making us all feel better. The sooner we face the need to restore the balance between productive and unproductive labor, the better. We need to shake out the debt, and we need a sound currency under the dollar, which is sadly and hideously overvalued.

Green Shoots?

The other day I wrote that there are no green shoots of recovery. Perhaps that is unnecessarily dour. Like any living organism, the economy is continually growing and dying away at the same time. So at any given moment, there are green shoots, in the form of new businesses, new ideas, new innovations. At the same time, at any given moment someone is being laid off, a business is failing, and so on.

The phrase green shoots suggest that the winter of recession is over and the spring of recovery has begun. I don't think we're close to the recovery, because while the process of deleveraging is occurring, it's still incomplete. When household, corporate, and government debt burdens have been reduced to something like their historical levels, then I'd say the process of deleveraging has been completed. But we're far from that point now. Consider the graphs to the left. The top two show rapid rates of issuance of government debt securities, far in excess of economic growth rates. The third shows the escalation of debt within corporations, most of it led by the financial sector, which has made leverage into an art form. The last shows the debt burden among households. These last two show debt as a percentage of GDP, which corrects for increases in wealth, productivity, inflation, etc. What we see is basically a tripling of the relative debt burden of households, and even more of an increase in the corporate sector.

What must happen is a purging of bad debts. There is no way that all the debts that have been incurred by households, the various levels of government, and corporations will be repaid. That means lenders are in for a serious hit. The carnage we've seen in the financial sector (for example, look at the DJ Financial Services Index) is just the beginning. What is needed is a shift away from finance toward productive economic activity, a sort of de-financialization, to use a fancy term. (there's a nice post on this at Below the Crowd)

It's clear that massive bailouts to the financial sector will be costly failures. No amount of money creation can prevent de-financialization from occurring. If we test my thesis, it will only come at the expense of inflation. But high inflation would also threaten financial firms, for high inflation cuts into interest rates, lightening relative debt burdens in favor of the debtor, harming the creditor, making it more difficult to both borrow and lend. High inflation would also make nominal interest rates rise, encouraging further deleveraging.