In April, I wrote Fork On The Road, which was published on Seeking Alpha as 4 Possible Market Scenarios. I think I have enough information now to update these scenarios and define investment strategy for the nearest future.
Scenarios, mentioned before:
Inflation and stagnation = stagflation
We had an amazing rally in commodities since March. Lately, we also had rally in gold, breaking through 1000 dollars per ounce. This is looking pretty much like dollar carry trade, or, as Nouriel Roubini said, the mother of all carry trades. Traders borrow dollars and buy everything they define as "hard assets", hoping for inflation. This might end bad, very bad indeed. Don't want to go into details, Roubini explains it much better. Despite bull run in commodities, inflation in USA is nowhere to be found. I still see probability of high inflation under 10%.
Japanese disease (Zero growth with zero inflation or low deflation)
Latest developments make this scenario less likely. The main problem in Japan is society, not economy. It's way too conservative, way too rigid, doesn't promote initiative, puts too much trust in managers and in government. I don't see anything like that in US. Banks are getting restructured, companies are laying off and cutting costs like crazy. It's painful for people, yes, but it's much better than sweeping problems under rugs, like Japan did for 20 years. The only similarity I see with Japan so far is carry trade.
Probability: around 10%.
Great Depression 2.0
Here I have to curb my enthusiasm. Probability of this development is higher now than it was back in March. The main change: higher taxes. They are creeping from all sides. Many local governments are raising taxes. Some states are raising taxes. Federal taxes are going to go up, it's almost given. I'm not against some tax increases in principle (no, I'm not Ayn Rand fan), governments provide essential services (at least some of them) and we need to pay for them. But I'm absolutely against any tax increases in the nearest future, i.e. before 2012. Otherwise we might repeat 1937 (just take a look at Dow chart!). All whining about deficit is misplaced, Japan has government debt at 160% GDP and counting, we are still below 100% GDP. Talks about reducing or ending stimulus programs are not improving my mood either.
Probability: about 35%.
Last quarter GDP numbers look great. Maybe US economy is recovering already. But accurate numbers are usually available 12 months later. And one quarter is not that important, in the last 20 years Japan sometimes had up years. Lots of good quarter reports, companies are beating profit estimates. But not many of them really grew revenues, profits are mostly driven by cost cutting. And dollar carry trade is looming huge. Despite of these developments, I still see this scenario as most likely one. After all, we just had a huge rally in stocks, and more importantly, in bonds.
Probability: about 45%.
I see lower probability of Japanese scenario and higher probability of GD 2.0. If we take a look at corresponding stock indices, it's bullish. Stocks went down and then stayed mostly flat in Japan in the last 20 years, but during Great Depression direction was up after 1932.
My stance continues to be bullish.