there is always the chance of a violent reversal in sentiment.

TO BE NOTED: From the FT:

"Expect plenty of mood swings before optimism returns

By Tony Jackson

Published: March 8 2009 14:22 | Last updated: March 9 2009 05:41

At a recent session with investment bankers and pension consultants, the arresting question arose of whether credit is the new equity. Specifically, might today’s asset of choice for pension funds be not stocks, but corporate bonds?

This reminded me of the depths of the bear market in late 1974. Then, too, there was much talk of the death of the equity. Sure enough, at the turn of the year the market took off like a rocket.

Similarly, I would not be greatly surprised if equities staged a revival shortly. Whether that would represent more than another bear rally is, of course, the central question.

But consider first the bond-equity thesis, since it is relevant. Fund managers, I am told, are now putting most of their new money into corporate bonds, and buying equities only when obliged to by cash calls.

The argument for that is clear enough. Bond yields are high and guaranteed, while equity dividends are now painfully unpredictable. And while both get wiped out by insolvency, equity goes first.

Official policy is also powerfully biased towards bonds at present. Internationally, there is a clear presumption that bank creditors will be protected while shareholders are cannon fodder.

Similarly, various countries plan to buy corporate bonds directly as part of their bank rescue efforts. Just when and how much remains unclear, but every little helps.

It might be objected that there are not nearly enough corporate bonds around to substitute for equities, and that they are highly illiquid. The answer to the first is that any such shift would have to be gradual anyway, since buying bonds heavily would mean selling equities and incurring huge writeoffs.

As to liquidity, one fund manager tells me he regards illiquidity as a distinct problem in equities as well. This is because, in pre-crisis days, the lion’s share of liquidity came from hedge funds and proprietary trading desks.

Both are now mostly gone, and the survivors have nothing like the old leverage at their disposal. Those investors impatient for a return to “normal” liquidity in equities may have a long wait.

It is of course possible, as some maintain, that corporate bonds are now in a serious bubble. But that, the cynic might say, does not invalidate the broader argument. If the institutions could not hold assets which are subject to boom and bust, what price equities or real estate?

The much bigger objection, obviously, is the threat of resurgent inflation in a year or two’s time. These days, the sophisticated fund manager will guard against that with inflation swaps. But in the post-Lehman world, these are only as good as the counterparty. Precisely the same holds for insuring against default through credit derivatives.

Mention of credit derivatives brings us back to the wider argument. Last week, the cost of insuring European non-investment grade bonds against default rose to a new record.

The fact that such insurance now costs marginally more than in the depths of the banking panic last year – when it was unclear how governments would respond – is significant. It tells us the crisis is now systemic at the corporate level, and that the outlook for defaults is still getting worse.

So much the worse for the banks, whose bad debt provisions may prove correspondingly inadequate. The risk is thus of a vicious circle, whereby bank capital is further weakened and there is even less lending to the corporate sector.

In which case, one might ask what chance there is of an equity rally. After all, Morgan Stanley last week raised its estimate of peak-to-trough falls for UK corporate earnings to 60 per cent – compared, it reckons, with a 57 per cent fall in the Great Depression.

But it is just such extreme propositions that should give hope to the optimist. I am by no means saying Morgan Stanley is wrong – merely that when such ideas can be seriously entertained, there is always the chance of a violent reversal in sentiment.

The same thought is prompted by the astonishing spectacle of General Electric selling on under four times earnings. Suppose, for the sake of argument, that GE’s hugely indebted finance business can indeed drag down what was once American’s most-admired company. But it would probably take a while, and there would be plenty of room for mood swings in the meantime.

Or consider the big UK insurers, which dropped by between 20 and 33 per cent on a single day last week. If the market were to turn, so would their capital ratios, and the result would be galvanising.

And above all, markets worldwide have collapsed to the point where even the US is somewhat cheap by long-term criteria. My bet is it will get cheaper still before we are done. What happens in between could be another matter."