What a difference three months makes. From the early March lows through June 1, broad stock indexes are up between 40% (S&P 500) and 65% (MSCI Emerging Markets). The price of oil has doubled from its first-quarter bottom, and yields on junk bond indexes have nearly been cut in half. The predominant worry has shifted from a debt deflation trap to a government-sponsored inflation problem. Investors have steadily renounced their extreme risk aversion and demand for safety. Equity, commodity, and credit markets are un­equivocally acting as though the credit crisis is over, and a new global economic recovery is on the way.

Apart from the typically strong initial rebound from a bear market bottom, two factors would seem to account for the extraordinary shift in the investment landscape over the past three months. First, the fear of financial and economic apocalypse was more intense than the vast majority of investors had ever before experienced. Since markets are a reflection of mass psychology, this led to a situation where sentiment became so negative and investment postures so defensive that risk assets had nowhere to go but up. Second, we have the exceptional circumstance of the greatest fiscal and monetary stimu­lus in history, and it is certainly working to revive global economic activity and asset prices. Ben Bernanke fa­mously said in 2002 that deflation is always reversible under a fiat (paper-based) money system. The surprise is not that he has been proven right, but that so many rejected his premise in the dark days of February and early March.

Few observers today doubt the ability of the Treas­ury and Fed to create inflation by widening the fed­eral deficit and expanding the monetary base in such an unprecedented fashion.

Now that we have had the powerful thrust off the lows, what happens next? Risk assets, especially in "high beta" asset classes like emerging markets and natural resources stocks, look very overbought. But a lot of investors—professional and non­professional alike—are still sitting on too much cash, and the pressure to get money invested in an environment where cash pays next to nothing, asset prices are moving up, and inflation expectations are rising, is intense.

While this bull market—only three months old—should be given the benefit of the doubt, the risk/return profile of stocks over the next couple of months appear neutral at best, given how much we have rallied from the lows. Within weeks, a mean­ingful correction will likely commence in stocks and other correlated markets, such as commodities, foreign currencies, higher risk bonds, etc. But the correction will probably be fairly shallow, retracing perhaps one-third of the gains since early March.

For investors who are holding too much cash rela­tive to their asset allocation targets, a patient, me­thodical approach to new buying should be em­ployed, especially in asset classes that have run up the most. It is still a very uncertain world, and there will undoubtedly be plenty of volatility in the months ahead, as opposed to the nearly straight line up that has occurred thus far.

Emerging Markets Leading the Recovery

In the wake of the financial crisis, the "decoupling" theory—that emerging markets could continue to grow with developed economies in the grip of severe recession—was dismissed. Now, with (1) the MSCI Emerging Markets Index up an impressive 38% year-to-date, versus single-digit re­turns for the S&P 500 and the MSCI EAFE Index (foreign developed mar­kets), and (2) certain emerging stock markets (i.e., China) back to levels prior to the collapse of Wall Street finance last September, the "decoupling" theory is back in vogue. There is an obvious element of truth to the theory, given the more favor­able growth and demographic charac­teristics of key emerging markets, but clearly these economies are inter­twined with the global economy, including the developed markets that still comprise a majority of global GDP. The recent strength of their stock markets suggests that the global economy is recovering.

Corporate Bond Spreads Continue To Normalize

Equity and commodity markets have recently confirmed that the depression is over, but credit markets have shown steady improvement since the fourth quarter of 2008, when the Fed began to apply its unprecedented support meas­ures. Short-term commercial paper and inter-bank lending markets were the first to recover. Three-month U.S. dollar LIBOR (the inter-bank lending rate) is at a post-crisis low of 0.65%, after having been as high as 4.8% last October. Corporate borrowing rates have declined steadily since late 2008, when the yields on corporate bonds rated Baa (the lower end of investment grade) implied default rates worse than those of the Great Depression! In the past six months, the spread between long-term Treasuries and long-term Baa-rated corporate bonds has nar­rowed from over 5.5% to 3.5% (see chart below), a level that is more typical of a merely recessionary environment, rather than a depression. Municipal bond yields have shown a similar improvement, and are back to more normal relationships to federal government bond yields.

Spread (in basis points)

Global Stock Market Valuations

Broad Stock Market Index Valuation Analysis

Notes:

Blue horizontal lines represent averate price-to-book multiples over the period.

Red horizontal lines represent 25th and 75th percentile price-to-book multiples over the period.

As a result of the 40% to 65% (depending on the index) gains we have seen off the lows, stocks have moved from (nearly) dirt-cheap levels three months ago to valuations that seem appropriate to mildly undervalued given the economic environment and the yields available in fixed income markets.

The economy is clearly beginning to recover, but the strength and durability of the rebound remains to be seen. After this initial bounce from government stimulus and pent-up demand runs its course, the economy may be vulnerable to a "rolling recession" type of environment as a result of private sector balance sheet rehabilitation, which will involve a multi-year process of higher savings and debt reduction.

Emerging markets stocks, which have delivered 15% per annum returns over the past five years (versus returns of minus 1.9% per annum for the S&P 500) are the most expensive of the major equity segments—relative to their history. Of the three broadest global equity segments—U.S. stocks, foreign developed markets stocks, and emerging markets stocks—emerging markets stocks are the only asset class whose price/book multiple is close to its historic average (see the following three charts). This seems appropriate when one considers the relative economic positions of emerging markets versus developed markets in the context of the past 15 years.

Bond Market Review

Long-term U.S. Treasury bonds were the top-performing asset class in 2008, but they have been the worst-performing investment in 2009. The 10-year Treasury bond yield has increased 170 basis points this year, and has jumped 120 basis points since March 18, when the Fed announced its intention to purchase Treasury bonds to hold down interest rates. It seems the "Bond Vigilantes" are back. This is a term used to describe Treasury bond investors who can enforce some discipline on a government that is potentially behaving very irresponsibly with respect to fiscal and monetary easing, and courting serious inflation risks.

A dramatic rebound in inflation expectations accounts for nearly all of the rise in nominal Treasury yields in 2009. In the past six months, the spread between the 10-year Treasury yield and the 10-year TIPS yield (which represents the market's expectation of the annual CPI inflation rate over the next 10 years), has jumped from under 50 basis points to nearly 200 basis points. Treasury investors are clearly becoming concerned about the $10 trillion in projected federal budget deficits over the next 10 years, and the ability of markets to absorb this supply. Hopefully, the recent jump in Treasury yields has delivered a warning shot to the government to restrain its spending excesses now that the financial crisis has largely been resolved.

Outside of conventional Treasuries, 2009 has been a rewarding year for investors in a number of fixed income categories, including corporates (especially high yield), emerging markets, municipals, and TIPs.

Alternative Investments

Commodities, natural resources stocks, and foreign real estate stocks all enjoyed strong gains in May. Like stocks, commodities are benefiting from economic optimism. Commodities are also benefiting from the "reflation trade," where rising inflation expectations stimulate the purchases of "anti-dollar" asset classes such as commodities, gold, resource/materials stocks, and foreign stocks. The U.S. dollar index dropped 4.9% in May, and, along with Treasury Bonds, has been one of the weakest asset classes in 2009. The U.S. dollar index is approaching key support levels in the 76-78 range (versus a current value of 79.2).

Accordingly, we would be surprised if the US$ had much additional downside risk relative to most other major currencies with respect to either the short- or the intermediate-term. The U.S. Dollar Index did spend nearly six months below the 76 level between March and September of 2008, but that period coincided with an extreme "blow-off" move in the price of oil, which exerted extraordinary downward pressure on the U.S. dollar. A rebound in the U.S. dollar would likely coincide with a pullback in commodity-oriented investments, foreign stocks and bonds, and risk assets generally.

U.S. REIT Dividend Yield (NAREIT All-REIT Index)

1/98 - 5/09

Following the recent rebound in REIT prices, and also owing to dividend cuts and dilution from new stock sales, the yield on the NAREIT All-REIT index has dropped to 7.4%, only 1% above the long-term average. This level of yield is uninspiring, given the negative fundamentals of the asset class. Other areas of the equity markets are more attractively valued, which argues for an underweight allocation to U.S. REITs.

J.D. Steinhilber is president of Agile Investments, a Nashville, Tenn.-based adviser. He can be contacted at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .