Tuesday, October 25, 2011

Credit Markets Are Still Not Buying It

Risk assets have been enjoying one heck of a rally the past few weeks. Stock markets around the world have been surging, with the S&P 500 up nearly 15% from its October 3rd low. The Russell 2000 Index of small cap stocks has exploded higher by more than 20%. Commodities have joined the party in recent days, with oil jumping by $18/barrel, to climb back above $93. The recent action in the stock and commodity markets seems to be giving the 'all clear' signal that a U.S. recession will be avoided and Europe is on the verge of solving their debt crisis.

Lost amid the recent euphoria, however, is the fact that the market most sensitive to a resolution of the European crisis – the European sovereign debt market – doesn’t seem to be following suit. In fact, some measures are actually worsening. For example, the Italian 5-year bond yield (shown below) recently reached a new high. If an agreement was really imminent, we would expect European bond yields to be plummeting, not creeping higher.

Here's the bottom line: While it is excruciating to be positioned defensively as stocks scream higher as they have recently, we don’t believe that anything has been resolved yet. Our best guess is that stocks are enjoying an overdue rally from deeply oversold conditions. We continue to keep an open mind and look for more definitive signs that it is becoming safer to accept more risk, but we don’t think we’ve reached that point yet.