Bear market rally (March - May 2009) R.I.P.

It takes nerves of steel to remain in cash, on the sidelines of a 30%+ equity market rally. With every 1% that the market moves higher, the greater the temptation to join the party for fear of missing out or being proved wrong. So it is strange that the recent rally coincides with a growing consensus that large amounts of cash await a correction before being invested. Thus, in the absence of improved economic data or company earnings, the market cannot move substantially higher while this cash pile remains uninvested.

An improvement in inter-bank lending alone, as measured by the falling TED spread, is not cause for a sustained bull market. Nor is the thawing of the primary credit market. What started as a financial crisis quickly spread to the real economy with devastating effect. Therefore, the problem is wider than the banks and is not solved, but rather one important part of the puzzle (the financial system) appears to be falling into place. However, there remains a lot to be done before we can say the financial system is fixed.

Since, this recession is unlike any other in living memory, it will take even more time to fix the real economy. What makes this recession different is the almost total collapse of the financial system coupled with a synchronised global slowdown in trade and growth. This combination will make this recession more severe in terms of both length and depth than any other in recent history. Whilst the worst of GDP and financial Armageddon may be behind us, unemployment and consumer deleveraging are likely to continue to deteriorate beyond 'normal' levels, extending the duration of this slowdown in the process.

On the plus side, the extent and speed of the response matches the severity of the problem. Trillions of dollars of toxic alphabet soup (CDOs, SIVs, CDS etc.) have been replaced with equal amounts of state-funded acronymed stimulus such as TARP, TALF, APF, QE... Excessive private sector debt has been replaced with public sector debt, something of which ratings agencies are well aware. Indeed, Moody's and S&P have put the UK on negative watch and this recession will undoubtedly claim more sovereign AAA ratings.

However, while the stimulus undoubtedly made the difference between depression and recession, we have effectively borrowed from the future to pay for the present. The huge increase in money supply and public debt: GDP ratio adds its own set of risks and will lower growth in the future. In an environment of higher perceived risk, investors demand higher risk premiums.

So, expect higher bond yields and lower p/e ratios, which will increase the cost of capital and constrict economic growth. Don't be fooled by the current euphoric bear market rally.