Contrarian ‘buy’ signals are strong, but so is the fear of debt

The contrarian “buy” signals in the markets keep increasing, but this doesn’t mean investors will rush and buy like in the good times.

Bank of America Merrill Lynch’s bull/bear indicator has only one component, the credit market technicals, in neutral territory.

The other five components are either in bearish territory — that is the case for hedge fund positioning, long-only positioning and equity funds – or in very bearish territory – equity market breadth and bond flows.

Sentiment is still extremely bearish. Source: Bank of America Merrill Lynch

Sentiment is still extremely bearish. Source: Bank of America Merrill Lynch

Normally, with the indicator as bearish as this, the contrarian “buy” signal that has already been in place for a while would trigger a rally.

Now, however, uncertainty about the future course of the global economy is too high. It’s true that the Bank of Japan has joined the ranks of those who punish commercial banks for holding reserves rather than lending them on, but the fundamental problem remains: the world is already drowning in debt.

Chinese debt has reached record highs and is dragging down on growth, as the country needs more and more debt just to stand still, while in Europe banks are still furiously deleveraging and businesses are still shy about taking on new staff or expanding operations. They already have too much debt, so why would they need to take on more?

The only area where lending seems to continue to grow and which is (still) favoured by banks is housing.

A recent paper by the International Monetary Fund (IMF) noted that house prices increased in real terms in almost all countries since the financial crisis.

This growth, however, is not the kind of healthy advance that can propel economies forward. In half of the countries, house prices are rising faster than income, indicating that probably the houses are bought for investment, rather than living purposes. In some economies, like the UK and Sweden, the housing bubble is already reaching dangerous proportions.

The wave of money printing by major central banks following the financial crisis has prevented the necessary creative destruction that could have helped the world rebuilt. And as state intervention grows, further destroying the free market, expect investors to respond by simply retreating from various asset classes.

It has already happened with commodities and emerging markets. Equities and bonds are the most liquid, so probably they are likely to sell off next. Property could follow, as the smart money will start getting worried that it would get trapped in the event of a stampede.

Ultimately, despite government intervention and attempts to inflate the debt away, the world will have to face the truth and accept a radical solution: debt forgiveness. The reality is that the quicker the debt of those who cannot pay it is forgiven, the faster the true recovery can begin.