A stock market bounce is coming, possibly starting as early as today.  Use it as a trading opportunity to generate some profits, but do not embark on a long-term “buy and hold” strategy because the problems in the global economy are far from over.  In an article posted at RGE Monitor, Professor of Economics at New York University’s Stern School of Business Nouriel Roubini observes the continuing risk of global stag-deflation, and he outlines what we must see from governments worldwide in order to regain any economic (and for this author’s purposes, investing) confidence.

We all know that economic activity in the fourth quarter of 2008 was atrocious.  GDP fell by about 6% in the US, 6% in the Eurozone, by 8% in Germany, by 12% in Japan, by 16% in Singapore and by 20% in South Korea.  The expectation is that the first quarter of 2009 will show less of a decline, or a softening of the recession.  Roubini quarrels with that notion however:

note that most indicators suggest that the second derivative of economic activity is still sharply negative in Europe and Japan and close to negative in the US and China: some signals that the second derivative was turning positive for US and China (a stabilizing ISM and PMI, credit growing in January in China, commodity prices stabilizing, retail sales up in the US in January) turned out to be fake starts. For the US, the Empire State and Philly Fed index of manufacturing are still in free fall; initial claims for unemployment benefits are up to scary levels suggesting accelerating job losses; the sales increases in January is a fluke (more of a rebound from a very depressed December after aggressive post-holiday sales than a sustainable recovery).

Those who believe that the recession is nearing an end will point to the fiscal stimulus packages announced and implemented by the U.S. and China.  However, as this author argued in the previous post on this blog, Roubini observes that without addressing the insolvency of the financial system, any fiscal stimulus or monetary easing is like “pushing on a string.”  As long as credit markets remain frozen, throwing more money at the problem is useless and will only lead to further problems, including handcuffing central banks when they need to be most involved.

Roubini: 

Fiscal and monetary stimulus is becoming more aggressive in the US and China – again less so in the Eurozone and Japan where policy makers are frozen and behind the curve. But such stimulus is unlikely to lead to a sustained economic recovery. Monetary easing – even unorthodox – is like pushing on a string when the problems of the economy are of insolvency/credit rather than just illiquidity; when there is a global glut of capacity (housing, autos, consumer durable, massive excess capacity because of years of overinvestment by China, Asia and other emerging markets) and strapped firms and households don’t react to lower interest rates as it takes years to work out  this glut; when deflation keeps real policy rates high and rising while nominal policy rates are close to zero; when high yield spreads are still 2000 bps relative to safe Treasuries in spite of zero policy rates.

A summary of Roubini’s solutions:

This aggressive and front-loaded and pre-emptive policy response needs to include:

·         massive and more unorthodox monetary policy easing to defrost credit markets even if this may imply central banks widening collateral and taking greater credit risk;

·         massive and front-loaded fiscal stimulus more on the spending than tax side and with income relief to agents with high marginal propensity to spend (poor, unemployed, state/local governments);

·         rapid takeover of insolvent banks – full nationalization – and their quick clean-up and re-privatization;

·         aggressive credit growth incentive for banks and financial institutions to stop the collective action coordination problem leading them to contract credit to even creditworthy households and firms;

·          use of proper and constructive credit forbearance (on capital adequacy ratios, on mark-to-market marks, on rating agencies destructive lagged downgrades);

·         Across the board reduction of the face/principal value of mortgage debt and other consumer debt for insolvent households as a case-by-case debt re-stretching of debt will not work;

·         Immediate doubling of the IMF resources and provision of loans/liquidity to emerging markets under liquidity and financial stress (with conditionality for those economies with severe macro/financial/policy weaknesses; with very light conditionality for the emerging markets with sounder fundamentals).

[SOURCE: The Rising Risks of a Global L-Shaped Near Depression and Stag-Deflation, Nouriel Roubini, RGE Monitor, March 2, 2009]

While this author is not averse to taking some risk in equity markets to take advantage of trading opportunities, such as the current market drop to new lows, one must still proceed with caution and take profits in light of deteriorating economic conditions.  For those who are looking for opportunities to park cash for a longer term, in a safe place with a decent return, the following list may be considered.  These selections are focused on the fixed income sector of the investing universe.  An investor can purchase individual bonds, build a bond ladder, or purchase a bond fund, depending on the level of diversity desired:

Corporate Bonds:

• Buy individual bonds or build a bond ladder.  Limit options to AAA-rated issuances.  Although interest rates may seem low compared to prior years, take into account the fact that inflation will be limited for the next couple of years.  The profit in these bonds will come in the form of price appreciation. 
• Buy a fund.  A good option here is the iShares iBoxx Investment Grade Corporate Bond Exchange Traded Fund (symbol: LQD).

Treasuries

• The short-term (less than 1 year) U.S. Treasury market has been overbought lately by investors seeking a safe haven for their money.  However, there are still opportunities in longer-term Treasury bonds (10- and 20-year maturities)
• An exchange traded fund option is the iShares Lehman 10-20 Year Treasury Bonds (symbol: TLH)
• For tax-advantaged accounts, such as IRAs, one may consider buying Treasury Inflation-Protected Securities (TIPS).  These are currently priced as if there will be zero inflation for the next 10 years.  Since we know that is not likely, TIPS offer not only protection against inflation, but also a good trading opportunity.  Look for announcements in April and July for the next 10- and 20-year TIPS auctions.  Also, this blog will post the information.
• There is also an exchange traded fund for TIPS: iShares Lehman Treasury Inflation Protected Securities Fund (symbol: TIP)

Municipal Bonds

• Individual municipal bonds offer terriffic tax-free opportunities.  However, like corporate bonds, investors should not stray away from AAA-rated issuances.
• Yes, there is an exchange traded fund for municipal bonds too: SPDR Barclays Capital Short Term Municipal Bond ETF (symbol: SHM)

Good luck!  Please send me an email (rawfinance@google.com) if there are any questions or leave a comment here.