The combined size of investment losses over the past year and a half and the growing uncertainty on the length of the current economic crisis has prompted an increasing number of investors to bail out of their investments and seek the relative safety of cash. Pundits that have been drawing parallels with the great depression of the 1930's point out that an eventual recovery of the stock market did not occur until 4 years after the crash!
The recession is likely to deepen further, as the impact of the ongoing credit crunch spreads into the wider economy. This will happen despite the robust government efforts to revive the economy given that there is still considerable debate as to what the correct policy response should be. Current economic measures also seem to be indicating that although government action to date may have succeeded in slowing or even stopping the "hemorrhage", the "patient" is still in intensive care as the antidote has yet to be administered. Trouble is that nobody seems to know what the correct antidote is, given that the crisis has no reference point in the past to draw lessons from!
In conclusion, given continued uncertainty, there is still a strong probability that assets decline further. For stocks, not having reached the bottom would mean that it is still too early to switch from defensive to cyclical sectors. Some asset classes seem more attractive than others, however. Take the bond market as an example. Treasuries have clearly been overbought (a result of the ongoing fear factor). If we compare their yields with the other end of the bond market spectrum (i.e. junk bonds), it is almost as if the "higher risk" spreads are pricing the equivalent of a world war (see graph). This makes them extremely attractive from a potential capital gains perspective. At the same time, however, it needs to be made clear that, as in the stock market, the yields are forward looking and, in this case, seem to be anticipating a much higher default rate, a scenario that could very well materialize the longer the recession drags on.
Many corporate bonds that were issued some 10 years ago, for example, are maturing this year. Given that financing costs have literally exploded, many of the firms that opt for refinancing are going to find themselves in dire economic hardship, raising the probability of bankruptcy. So although non treasury bond yields look attractive, the risk of default should clearly be factored into the investment decision making process to limit damage in the event that the recession turns out to be a protracted one.
