Bonds Contradict Recent Stock Progress

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Another very volatile week! Friday’s mere 61-point loss on the Dow Jones Industrial Average on very light volume brought a frenetic week to a relatively calm conclusion. Reacting to a possible unwinding of the Greek rescue plan, the Dow lost 573 points on Monday and Tuesday. Fed Chairman Ben Bernanke’s reassuring words that the Fed retained numerous options to shore up a flagging economy prompted a 386-point recovery on Wednesday and Thursday. The net of all action was a 2% loss for the week.

This week demonstrated conclusively the market’s responsiveness to headlines and rumors. The Dow rose and fell 100 points or more several times during the week as rumors circulated about prospects for the Greek bailout. Clearly, traders–not investors–had control of the buy and sell levers.

Trading closed for the week with the Greek parliament debating the fate of the Papandreou government and, in turn, with the European debt rescue effort hanging in the balance. It is remarkable that while the heads of state of Eurozone member nations have been meeting repeatedly for months, they have yet to agree on a concrete plan of action. Given the dire consequences that would flow from one or more sovereign defaults and from the resulting damage to the banks holding such bonds, it is hardly a surprise that individual investors are leaving the stock market in droves. It may take years for many of them to return. However, notwithstanding this week’s market decline, traders have been pushing prices up for several weeks with apparent confidence that governments and central bankers will prevent defaults from leading to a banking system failure. Whether or not that confidence will be rewarded is an open question.

Longer-term stock market price patterns still look negative. Ned Davis Research’s study of 45 world markets shows 41 of the 45 with stock indexes trading below their respective 200-day moving averages, a line viewed by many analysts as the demarcation between bull and bear market conditions. Additionally, 40 of those 45 moving averages have turned down, serving as confirmation of a bear market in the eyes of many.

Further disagreement with traders’ recent confidence comes from the bond markets. A vast amount of money has fled to risk-free U.S. treasury bills, which yield effectively nothing. Money has likewise poured into the bonds of safe-havens like the United States and Germany, each of which can borrow for 10 years for a mere 2%. In contrast, despite substantial supportive buying by the European Central Bank and the promise of further support from the block of Eurozone nations, Italian 10-year bond yields have soared to about 6.4%. Most analysts fear that yields over 6% will preclude distressed countries like Italy from servicing their debts and growing out of their current financial distress. The bond market is casting a powerful vote of no confidence in the efforts of politicians and bankers to cobble together a viable solution to the growing European debt crisis.

If Eurozone problems cannot at least be deferred, the consequences for the world financial system could be severe. When ongoing financial success depends upon programs crafted by politicians and self-interested bankers, we are not looking at a normal investment landscape, but rather a casino in which the standard rules of investment only minimally apply.