A Top of the Market Quote From the Chairman of CIC

I recently came across the quote below from Lou Jiwei, Chairman of China Investment Corp, which pretty much sums up the investment philosophy of fund managers chasing this rally 60% off its lows.

“It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

As long as the US and China continue to flood their economies with endless amounts of monetary and fiscal stimulus this mother of all bear market rallies could continue. However, with unemployment approaching double digits, credit in the real economy evaporating by the day (how many retailers have reintroduced lay-a-way programs??), and rising food and energy costs pinching the American consumer, this rally has far exceeded any justifiable levels based on the fundamentals.

Even more excessive has been the massive rebound in the high yield market. Whereas the average bond traded at 55 cents on the dollar at the depths of the market low in December 2008 (an absolutely once in a generation buying opportunity), the average high yield note now trades at a very rich 92 cents on the dollar. Nearly all CCC or lower rated bonds have rallied by over 100% off the lows, with many having high probabilities of receiving no recovery in a bankruptcy scenario.

While glimmers of an economic improvement have justified a rebound in credit, particularly given the depressed levels at the trough, fund flows are largely driving the compression in credit spreads. Flush with liquidity, bond managers are compelled to put money to work. Most professionals are shaking their heads, but as long as fund flows remain robust, they have to put this money to work no matter how overstretched the credit markets seem.

Bernake & Co. appears committed to maintaining a very accommodative stance. Backward looking measures of unemployment, inflation, and capacity utilization warrant their concern. However, just as steady interest rate increases in 2005/2006 eventually choked off the housing/LBO credit bubbles, the first hints of tightening by the Federal Reserve will undoubtedly cut short this resurgence in credit.

Liquidity is so elusive in the credit markets (particularly in high yield). Investors always think they can get out before the house caves in. Among the many lessons of 2008 is how quickly liquidity can dry up when everyone heads for the exits. Investors ought to heed this lesson as they ponder chasing this rally in credit higher.