WTF!

How the hell does one make sense of the world now?

How does one predict where the markets will next head?

To figure that out, not only do you have to figure out the trajectory of the economy --- strengthening, though soft? or softening, though positive? or softening into contraction? --- and to do that you need to (a) figure out the underlying trend of private domestic demand, (b) determine the impact of inventory adjustments, (c) evaluate the incremental impact of changes in fiscal spending, (d) ascertain the contribution of net exports given differing behaviour of regional growth (e.g. is a strong China good for U.S. net exports? slowing Europe?)

But then you have to throw in the wildcards of:

the election and the prospective outlook for the extension of the Bush tax cuts

QE2 --- what impact it will have on the economy (+ve? none? -ve?), and what first-order impacts it will have on the markets (baked in the cake? lagged?), plus the second-order feedback loop effects between the markets and the economy and vice versa

the mortgage foreclosure mess

beggar-thy-neighbour geopolitical/economic policies, including currency wars and potential for trade wars

The current period seems all too familiar: a period of the market's stubborn refusal to acknowledge the writing on the wall. That the economy is weak, there is no question. If that were not the case, then QE2 would not even be in the discussion. But it seems many view this as a win-win environment: either the economy turns and all is well with the world so asset prices (except bonds) go up; or QE2 is necessary and asset prices (including bonds) go up! Hallelujah!
Such people never learn.

In 2000, in the face of crumbling fundamentals, the market stubbornly ignored valuations, treating valuation analysis as a quaint historic notion of no current relevance. Then the market fell over 50%.

In 2007, in the face of a monstrous debt bubble and housing market crash, the market decided to keep dancing rather than face the music; and then, once it did realize that subprime really might not be contained, it somehow imagined that the Fed could somehow solve all the world's problems with lower rates (the distinction between illiquidity and insolvency never having really been appreciated). Then the market fell over 50%.

Today, the problems seem worse, and the potential for solutions more remote.

Take just the mortgage situation alone:

Banks are still insolvent: their balance sheets and their earnings statements have been goosed by accounting gimmickry, including mark-to-model and off-balance-sheet legerdemain, as well as reducing loan-loss provisions even as non-performing loans continue to escalate, i.e. all the same sort of zombie-bank stuff used in Japan.

Okay, well, I'm quite willing to acknowledge the obvious: the U.S. government has been bailing out the banks for the last 3 years, injecting capital without taking charge, not only letting the banks continue with their standard operating procedures, but changing FASB rules to boot --- and they're NOT about to abandon that strategy now!

So perhaps the fact that the banks are insolvent is irrelevant --- there will be no second shoe to drop in the credit crisis, the next wave of mortgage resets and the CRE situation notwithstanding.

And surely the Feds would not let foreclosure-gate put at risk their grand master plan! How could they possibly do that? What would be the point of QE2 if Obama et al had any thoughts of actually going after the banks for foreclosure fraudulence? The former would have no chance of success if the latter were happening, so, clearly, the latter won't happen.

But but but

But foreclosures in the U.S. are not a federal matter, they're governed by state law. Hmmm.

And...

But BoA, JPM and Citi are each down 5-9% this week. Meanwhile, 5yr CDS on BoA have shot out to 193 from 152. Could this be the tip of the iceberg?

In 2007, when the ABX started falling, most of the Street remained in the "contained" camp --- losses would be minor; there was no need to over-react --- but it didn't take too many months for the ABX to drop 60% and for the S&P 500 Financials index to drop from a 2007 high of 510 to a 2009 trough of 78. Ay, carumba!

Have the problems from that period actually been fixed? Are the underlying cashflows to support all that debt that still remains actually there? Have either employment or housing prices rebounded to give support to mortgage-based valuations? Or, perhaps is there just a lot of smoke and mirrors? And not only that but now actual malfeasance. (If you don't know who owns the loans or who has the right to foreclose, can a raft of lawsuits investor losses and bank writedowns be all that far behind?)

Count me as a skeptic.

But even if the skeptic in me is right, what about QE2? Perhaps the banks could be as messed up as possible, but if the Fed still gives them free use of the printing press (even a badly-managed bank can make money by borrowing at 0% and investing at 3 or 4%), especially if the Fed telegraphs that it will buy whatever the banks have already bought, and will do so at higher prices. How easy is that!

So even if QE2 can't do much for Main Street, surely it can do something for Wall Street. What could possibly go wrong?

Lots, that's what. How about a full-fledged currency war-morphed-trade war?

Too many known unknowns, never mind unknown unknowns.

All I know is, whenever people think about the market being in a win-win situation, they've got their head stuck u-no-where.

Stock prices and bond yields certainly could go up from here. I just don't think that's the way the odds are tilted. Not will all those wildcards.

All in all, I think the market's interpretation (the stock market's, that is; the bond market is always right! well, maybe not always --- like early 2010, when Treasury issuance, inflation and bond vigilantes prevailed --- but at least the bond market is always right before the stock market!) of current events is no more correct today than it was in either 2000 or 2007. Just another flight of fantasy.