The financial crisis is not over yet!

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. However, if on top of this wealth deflation we had a rise in consumer price inflation, then households' real incomes would shrink and the recessionary impact of the asset deflation coming from the bursting of the bubble would be compounded by a loss of real income.

So it is possible that in the worst of all possible worlds, inflation in consumer prices at a time of deflating assets and contracting real economic growth could lead to stagflation, which implies no growth plus inflation.

In such an environment the economy would be hit by a triple whammy: Falling asset prices and declining wealth, rising inflation, which erodes real disposable income, and rising unemployment, which also attacks people's income and purchasing power. In fact, when the market realizes that lowering interest rates will not help the US economy much, it is likely that the dollar will tumble.

The only question is against what and what the economic consequences of a weakening dollar will be. Some economists fear that a weaker dollar will lead to rapid increases in the prices of imported goods, which will then add to the inflationary pressures we discussed above.

However, I find it difficult to see how the currencies of emerging economies could appreciate against the dollar as competitive devaluations have become the order of the day - in Asia largely as a consequence of a declining Japanese Yen. And pegged currencies, such as the Argentine Peso, are increasingly under pressure.

Therefore, for as long as emerging economies experience deflation in US dollar terms, as a result of their declining currencies, their export prices in dollars are likely to remain weak and not add much to US import price increases. But the outlook of commodity prices is another matter.

Let me explain. I find it difficult to see the US dollar declining by more than 10% or 20% against the Euro, especially if the Yen remains weak. But what could happen is that the dollar tumbles along with other currencies against a basket of commodities and the price of gold.

There is a gigantic pool of foreign money invested in the US. This money is very volatile and once the still optimistic perception among foreign investors about the US changes, a sudden shift out of US dollars into another asset class such as the Euro or gold could rapidly take shape.

Thus, in an environment of a weakening US dollar, high quality Euro-denominated bonds, whose yields look set to decline further, appear to be more attractive than U.S treasuries. In fact the ECB's current inaction in the face of deteriorating economic data is bullish for bonds and Euro denominated bonds will benefit as consensus forecasts for Europe are downgraded.

Now, it is true that in a weak economy, commodity prices are unlikely to rise much. However, some commodity prices can rise even if there is a horrendous economic environment, simply because of temporary shortages (oil, shipping rates) or because of natural disasters (pork prices soared because of the foot and mouth disease).

In this regard, I think that grain prices have the potential for an explosive upward move should there be some weather-related problems this summer. Moreover, investors ought to realize that commodity prices have been in a bear market for more than 20 years and that compared to financial assets they have never been cheaper.

So investors who feel, as I do, that stagflation is a possibility, ought to buy gold, as the excess liquidity the Fed is creating might also flow out of dollars into the gold market rather than into other currencies.

In sum, therefore, I am now somewhat negative about US Treasury bonds. I concede that they might continue to out-perform equities for quite some time, although during bear market rallies, equities could perform for a few month far better than bonds. The long-term out-performance of bonds compared to equities does, nevertheless, not necessarily mean that bonds appreciate in value. Bonds could simply move sideward or down somewhat, while equities continue to sell off.

But, sometime in future we shall see a huge gold bull market and, therefore, the depreciation of the US dollar will not occur as much against other currencies as against the gold price. By then, you can be sure that the world's central bankers will again become gold experts. And after a substantial rise in gold prices, they will then buy back all the gold, which they sold in recent years at low prices!