Why We're Still Underweight Equities (Just Less-So) - II

We've read a few too many times in the past two weeks that equity markets can, even should, rise sharply in the middle of recessions. And we keep reading that a second-half '08 economic recovery may be back on the table after all.

If this sentiment is becoming too common, recently-bid-up equity markets are becoming more vulnerable to the rash of further economic slowdown headlines that are coming in the next couple of quarters. (That is why most of our efforts to narrow our equity-underweight in recent weeks have been focused on major secular trends with less economic sensitivity.)

Pending bad news often seems well-understood and discounted .... until it arrives and stares investors in the face. And arrive it will. Every day that the credit market remains tight -- and tightens in many parts of the world -- means there's less new investment going into the economic pipeline, and less economic activity in the future. The massive credit unwind in the past six months is stealing significant economic growth from the future, and the credit unwind is still occurring in a pronounced way. (Again, that's why we're sticking with areas of the economy that are grabbing a rising share of investment, such as agriculture, water, and energy efficiency.)

It may be true that there's less chance of an financial collapse now than perceived just a few weeks ago, and that the reduced "tail risk" has helped lift markets in recent weeks. But if (we think when) world economies slow more substantially later in '08, investors will become more fearful of equities. We're waiting for that "second wave" of equity market fear to significantly raise our equity weighting.

A brief FT article tonight adds a few more specifics our concerns about another wave of economic slowdown news hitting market sentiment soon:

• Treasury sell-off hits housing recovery hopes

  The Fed sees the rise in yields as signalling increased market confidence in US economic prospects.

  However, mortgage rates also moved higher, making it more expensive to buy homes and less likely that existing homeowners will be able to refinance mortgages. [Recall, perceiving "the beginning of the end" of the housing crisis has been seen as a necessary condition to end the financial crisis.]
  

  Rates on 30-year fixed-rate mortgages rose to 5.87 per cent from 5.63 per cent a week ago, Bankrate.com said. Jumbo mortgages, those of more than $417,000, rose to 7.19 per cent from 7.06 per cent.

  “The back-up in yields is a concern as it will damage the economic outlook,” said Jane Caron, strategist at Dwight Asset Management.

  The three-month London interbank offered rate – Libor [to which trillions of dollars of loan costs are tied]– increased to 2.91 per cent from 2.71 per cent this week, indicating underlying stress in the financial system.

  Stocks rallied, said Anthony Conroy, head of equity trading at BNYConvergEx, because “the equity market is focused on a second-half recovery...and is not paying attention to the rise in bond yields yet.