Being given a chance to re-load on short positions

Sean Maher at the blog Dead Cats Bouncing has been very good at calling turning points in market sentiment. I wish I wrote his latest post, because I totally concur: Equities: S&P heading to 600 via 1100?

Back on December 7th I noted that 'the probability of a very dramatic rally in equity markets of 20% in coming weeks is high and rising, taking the Dow over 10,000 again' and I stand by that view, implying up to 1100 on the S&P. The mountain of cash on the investment sidelines (about $8.8trn) earning a minimal return in Treasuries and money market funds as the Fed cudgels conservative, prudent savers and marches them up the risk curve, will get redeployed over coming weeks as confidence in the rally and recovery momentum grows. I also suggested that long term energy exposure was attractive, as the oil price had undershot to the downside unsustainably, and that view is now being vindicated by strong sector performance. However, make no mistake, this bear rally which will run maybe 33-40% from the November lows will be a wonderful opportunity to raise cash or hedge exposure before a new panic arises by late Spring or early Summer, re-testing and quite possibly crashing through the recent 740 S&P low. We're entering Act 3 of this horror movie, and after a respite for dramatic effect, that's when things get really gory.

Not only will we see a huge spike in US corporate and municipal defaults through mid-year, rising geopolitical risks resulting from the politically destabilising fallout from the economic slump, and a likely further fall in S&P 2009 earnings forecasts to $50 or below but we're in a bizarre and dangerous scenario where monetary policy has become divorced from money. The Fed, rather than passively supporting the necessary cyclical de-leveraging process, is actively targeting asset prices, hence the massive increase in its balance sheet in recent months as it seeks to make non-liquid assets attractive to banks to get them to lend again. Monetary policy is essentially focused on inflating America's way out of a smothering debt pile by any and all means possible; so far, US money supply has exploded, but the velocity of money ie its multiplier effect through the real economy via credit creation, has remained frozen.

The US monetary base (basically its currency in the hands of the public and the reserves in the banking system) has soared to $1.7 trillion, much of this due to commercial banks depositing reserves at the Fed, which seems like a copy of the Japanese strategy of boosting a ZIRP regime by kick-starting interbank lending, with each bank comforted by the certainty of their counterparty's massive excess reserves.

However, that Japanese plan only ultimately worked when banks finally disclosed the full extent of the toxic debt on their balance sheets, and that transparency is still lacking in the US and elsewhere. There are many dangers in this frantic monetary fire-fighting which I will discuss in future posts, notably losing the confidence of key foreign buyers in the Treasury market and dollar, despite current efforts to 'game' long-term yields down. There is a real risk of igniting serious inflation beyond 2010/11 if the monetary transmission mechanisms begin to normalize. Hedging against long-term inflation via hard asset exposure and TIPS is wise on this view. After the TARP debacle, US economic credibility this year is on the line as never before and any missteps will be cruelly punished by global investors. Enjoy the ride.