Tuesday, April 15, 2008

The Market May Be Setting Itself Up For Extended Move Higher

The negative news sentiment seems to increase on a daily basis. Where the news media once talked about a "possible recession", the media begins most of their economic statements by stating the economy is in a recession. The negative aspects of the economy seem to be growing:
  • higher energy prices
  • high agricultural prices
  • high commodity prices
  • high real estate foreclosure rate
  • unemployment trending higher
and I could list others as well.

This negative news flow has certainly had an impact on investors. A March 2008 report by the IMF notes that investors report near record levels of risk aversion as detailed below.

(click on charts for larger image)

The Investment Company Institute (ICI) reports record levels of cash in money market funds too. As of April 9th, ICI reports money market assets total a record $3.5 trillion. This represents a 44% increase over cash balances a year earlier. So what is the so called "smart money" doing?

In a post I wrote a few weeks ago, The Commodities Stampede: Is the Smart Money Heading for the Exit?, commercial traders have record level short positions in commodities. According to a Bloomberg report, Larry Fink, of Blackrock, is telling investors to add more risk. Blackrock is advising investors to buy riskier assets such as bank loans, mortgages and high-yield debt. Some of the data Blackrock is likely reviewing is the near record spreads in high yield debt.

Source: Bespoke Investment Group

When high yield spreads begin to narrow, the return on high yield investments should increase due to an increase in high yield bond prices. If the historical correlation holds, stocks would move higher as high yield bonds have a positive correlation of .50 to the S&P 500 Index.

In the end, an investor needs to focus prospectively on where the high yield and stock market may be headed. Looking forward takes on the additional risk that ones forecast may not unfold immediately. To minimize this risk, averaging into the chosen asset classes may be appropriate.

Note: The IMF report was originally highlighted by Barry Ritholtz of The Big Picture website.


Global Financial Stability Report
International Monetary Fund
April 2008

High Yield Spreads
Bespoke Investment Group
March 4, 2008

Cash on the Sidelines
Business Standard
By: John Authors
April 10, 2008

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