Still more reason to stay short than long in financial markets

Over the past week global financial markets turned volatile but only China delivered a meaningful sell-off as it took further measures to curb inflation, including direct price controls on food.

Wall Street managed to pull off the largest IPO in US history with the return of the ‘New’ General Motors to the market. But this feat of market manipulation seemed so openly understood that the miracle is that the participants went along with it.

‘New’ GM

Will those happy owners of ‘New’ GM now turn around and dump their stock? Well you do have to wonder why they would want to continue owning shares in the largest US manufacturing company in the middle of a long economic slump. Are the recovery prospects for such a huge behemoth that great?

‘New’ GM quickly looks yet another accident waiting to happen. Inflation is the other obvious 600-pound gorilla wondering Wall Street. Where will he pop up first? In the bond market or commodities? Or what about the stock market itself?

Pre-QE2 the markets thought this policy might somehow magically inflate all stocks to higher levels. Now there is a bit more sense in the market and a questioning of QE2.

For inflation is not great news for the profits of most companies. Input costs usually rise rather faster than they can be past on to consumers, especially in an economic slump. So the electricity bill goes up and the factory making widgets has to knock that off its profit margin. Same thing if it is making large American automobiles.

Inflation and deflation

Then again inflation is also a form of currency deflation as it means money buys less. If prices go up those on fixed incomes consume less, and so firms sell less product.

No country ever money printed its way to economic success, and QE2 will be no different for the US. But how quickly that self evident truth will be reflected in stock prices is very hard to say with manipulation in the hundreds of billions of dollars. We have no precedent to analyze this, except perhaps China over the past couple of years.

Look at the weakening of the Chinese stock market over the past week and you perhaps have an answer. Markets do have a habit of correcting just as soon as the writing is clearly on the wall. Staying short makes more sense than going long after last week’s volatility, and this article has not even mentioned the looming sovereign debt crisis in Europe that Ireland has put back on the agenda.