The Big (Double) Dipper
Further to yesterday’s musings on the return of risk appetite, I thought it would be appropriate to elaborate on the progress of an older view of mine: that of a double dip recession, which I first pointed out in December 2008. The double-dip recession scenario relied on the following checklist:
- A collapse in the economy. Check.
- Deflationary fears replacing inflationary fears. Check.
- Wildly aggressive moves by the Federal Reserve and the government to reinflate, including quantitative easing and, potentially, buying every risky asset in sight in an effort to restore market confidence and put a floor on asset prices. Check.
- A return of inflation. This would be signalled by everything from commodity prices picking back up, to dollar weakness, to implied breakeven inflation increasing, to equity markets rising. Tentative check, as we believe that these signals are beginning to materialise.
- A pickup in economic activity. The sense that things are returning to ‘normal’ would help spur private investment and consumption, albeit not nearly as vibrant as seen in the previous five years. No checkmark next to this box yet.
- A suddenly restrictive monetary policy, as the Federal Reserve and other global central banks attempt to get the inflation genie back into the bottle. The trickiness of this stage is the use of quantitative easing and the purchase of non-traditional assets, which makes it difficult to see how the Fed will unwind its positions, and how quickly it will be able to do so.
- A second dip in economic activity, akin to that seen in the early 1980s recessions when the Fed tightened policy to get inflation under control, or even in the 1937 economic downturn when the government fiscal stimulus was shut down. This second dip would be the dagger in the heart for equities, and confirm the current run-up in asset prices as a bear market rally for the ages.
So as you can see, while there may be ‘fundamental’ reasons for the current upturn (namely monetary and fiscal stimulus), it still seems clear to me that the long-term fundamentals required for a sustained, multi-year bull run remain pretty poor. And investors hoping for a long-term rally are likely to be disappointed if the scenario above plays out. From the perspective of technical analysis, as shown in yesterday’s post, it is possible to envisage how this fundamental double-dip view will play out. There is a tentative bottom forming across several asset classes, from commodities to stocks.
However, just as I do not believe that the final shoe has dropped from a fundamental standpoint, nor do I believe that the downturn is over on a technical basis. A few weeks before the rebound, it looked like the Dow was headed to 5,000, and I believed that it would either happen the quick and easy way or the long and hard way. It looks like we may be headed down the latter route, with a rebound taking the Dow all the way back up to 9-10,000. But as the double dip hits home, stocks collapse once again, confirming the bear market suckers’ rally. This could take months or even years to unfold. In the meantime, as I have been stressing, this is a trader’s market, not an investor’s market. Positions should be placed accordingly.