Smart Markets, Foolish Choices

My brother is smart, so smart.
I love my brother; I send him money every week.
-- David Brenner

The conundrum of the moment is the apparent divergence between stocks and bonds. Which market is "smarter" and therefore to be believed? Let's review the bidding.

Stocks have firmed from last October's lows and are toying with levels first reached in July 1997. How much more bullish about the state of the world can you get?

Bond yields have moved down to, depending on the maturity, levels last seen during the Eisenhower administration. Our solons at the Federal Open Market Committee, when they're not dispensing advice to Congress about fiscal policy and buying copies of Useful Japanese Phrases, are fretting about deflation and hinting that rate cut No. 13 may be necessary. That's bearish, isn't it?

Corporate bond spreads are falling. Bondholders stand ahead of stockholders when the sheriff arrives, so it stands to reason that if you're not willing to invest in the bond, you shouldn't be willing to invest in the stock. There are, however, many cases wherein you should be willing to buy the bond and avoid the stock like the plague, and that has significance for answering our key question. Overall, the interpretation of narrower corporate bond spreads is bullish.

The yield curve remains very positively sloped, and that reflects optimism about future growth and concern over future inflation. Historically, this has been bearish for bonds, but that hasn't held true in this cycle.

The European Central Bank (motto: "12 Countries, No Clues") refused to cut its benchmark rate from 2.50% because of concerns over inflation. Let's see: The stronger economy with the weakening currency and the massive twin deficits is worried about deflation, while the weaker economy with the strengthening currency is worried about inflation. As a friend says, "you can't fix stupid." Our continued exposure to such mismanagement must be considered bearish for the economy, and quite possibly for the entire solar system.

The dollar, which like bond yields remained strong during the 2001 rate-cut extravaganza on the mistaken belief that monetary policy would stimulate the economy, is falling like a rock.