The financial crisis is not over yet! (page 1 of 2)

Since then, the NASDAQ has lost more than 50%, the S & P 500 is down around 15%, while US Treasury bonds have provided solid low risk returns and significantly out-performed equities. But, now, that long-term T-bond rates have approached their long-term average of 5% and the major US stock averages made recently new 12 months lows, perhaps it is a good time to re-examine the outlook for both stocks and bonds.

Starting with stocks, it seems to me that we need to go significantly lower in the US before reaching levels, which would offer a compelling combination of low risk and high returns. Valuations are still very high and investors are still far too optimistic about future earnings growth and about the market's recovery potential.

While stock investors have experienced huge losses - over $5 trillion so far - there seems to be little in the way of the type of capitulation normally prevailing at market bottoms, which would include very depressed sentiment and low volume. Thus, while the US stock market may continue to trade up somewhat in the next few months, at very best I would expect a trading range of between 1,100 and 1350 for the S&P 500 in the foreseeable future.

Moreover, I am leaning toward the view that we will decline further as time goes by and as it becomes evident that there will be no economic recovery in the second half of 2001.

In the case of bonds, the big question is whether they will continue to appreciate. After all, over the last 20 year long term Zeros have compounded at close to 22% a year (who says that stocks always outperform bonds?). Obviously, at some point the great US bond bull market, which saw yields on long-term treasuries decline from 15% in 1981 to around 5.4% recently, will come to an end.

Bond bulls believe that the Fed will continue to aggressively cut interest rates and that with the economy slowing down further, Treasury bond yields will eventually approach 4%. Possibly, but I have begun to be somewhat concerned about the outlook for US treasuries.

For one we have built over the past several years frightening imbalances, including the US trade and current account deficits, excessive monetary and credit growth, leverage among consumers and the corporate sector, a hereto strong US dollar, deflation in Japan and emerging markets, and so on.

In this environment it is, therefore, difficult to predict an outcome, since by making credit easier the Fed thinks that they can prolong the expansion or at least turn the decelerating economy around. However, increasing credit at this stage of the game is unlikely to help much, and in fact, it may prolong the slowdown, because what we have is not just an inventory problem but global huge over-capacities.

Furthermore, according to classical Austrian economics, resources have been badly misallocated, because of the cheapness of credit, in both the stock and credit markets. Therefore, in the present situation cheap money could make matters far worse since the recent very long period of an above-average rate of growth in money will eventually have an inflationary impact.

The relationship between money growth and inflation is still there and in the long run, inflation is a function of money supply growth. Thus, it should have come as no surprise that we had recently a very slow up-tick in the rate of inflation. The problem with this is the following.

When a bubble busts, investors experience a deflation in asset prices. In other words, in the US, already $6 trillion of market value has been lost since last March, which obviously reduces the wealth of households and corporations, and their spending power.