Where to from here?

The fixed income markets are in a very tight spot. Swap spreads are the highest in at least 20 years. There is a lot of pricing dislocation as investors flee to quality. The corp. bond market has virtually dried up, and apparently off-the-run treasuries were trading sluggishly on Friday. Traders are very nervous. Pricing dislocations abound. There has even been some "end of the world" type talk.

Is this the end of the world? Maybe, but probably not. There are certainly some aspects of the current situation that very serious, and probably make it worse than previous episodes. In 1998 there was essentially one hedge fund in trouble, albeit one that was very large and had significant linkages throughout the major banks. But currently, it is the banks themselves that are in trouble, and it is not just one. Bank capital is low and declining, forcing banks to protect their balance sheets. An incipient recession and housing bust provide a negative backdrop, while large CDS exposures and mark-to-market accounting threaten to amplify price declines. The Fed has increased liquidity multiple times over the past 7 months, but it has failed to correct the problem or reduce the sense of crisis. Even worse, there is no leadership and no reasonable proposals on how to get out of the mess.

In the past, such overly negative situations have signalled major buying opportunities. Is now such a time?

I would argue that we are near time-wise, but still have some way to go price-wise. Prices tend to go down exponentially in a "blow-out" situation, and we have yet to see such movements. Fixed income is arguably much of the way there already. Equities have started, but as I mentioned before, the movement has been remarkably gentle given the situation in the fixed income markets. Equities almost certainly have much farther to go. Commodities may act as the signal of the final turn. There appears to be a lot of speculation and risk capital in the commodities. When that money is finally pulled and prices get hit, it will be a strong signal that the end of the slide is nigh.

MARKET POSITION: EQUITIES - SHORT (11 units); GOLD - LONG (1 unit)