For those of us who have lived through major bear markets there is significant skepticism about the current equity market rally. Here are some arguments for and against:

Leverage. It always gets blamed whenever bad things happen to investments and markets. But leverage in itself is neither good nor bad. Leverage is a magnifier of returns, both positive returns and negative returns. The idea behind leverage is that it can be used to make a small return into a big return. Here is how it works. You have 10 dollars. You want to invest 100 dollars. You borrow 90 dollars. You pay for the 90 dollar loan, you get paid, hopefully more than that on the 100 dollar asset. And if it doesn’t you have negative gearing and you hope to high heaven that the asset appreciates in value. Of course asset values fluctuate.

1. Equity and credit markets continue to fall.
2. Investors have shifted their allocation into cash and government bonds.
3. Correlations between assets is not 1. In fact, correlations between hedge funds and other asset classes such as equity have fallen from 95% in 2006 / mid 2008 to 70% currently.
4. Moving allocations into a risk free asset does not monotonically reduce portfolio risk. There comes a point at which adding to the risk free asset increases portfolio risk.
5. Moving capital en masse into any asset, even a risk free one, eventually increases the risk in the asset, and consequently in the portfolio.
6. If you do trust volatility as a risk measure, hedge funds have better Sharpe ratios which recommend overweighting them.
7. If you don’t trust volatility as a risk measure, the absolute loss incurred by hedge funds has been less than for long only passive strategies.

February was another difficult month for hedge funds. If anyone thought 2009 would be an easier year for hedge funds, think again. Hedge funds lost 0.51% in February, compounding January’s 0.09% loss for a year to date loss of 0.60%, according to the HFRI Index. Fund of funds managed a smaller loss of 0.31% which together with January’s gain of 0.67% resulted in a +0.36% return for the year.

Broad indices, however, hide interesting detail.

We have a crisis in debt that started in the US housing sector, that spread to the US financial system and then to the US economy. As a result, Asian equity markets and economies have suffered far worse than the US or Europe. Makes perfect sense, doesn't it? It does. And it will have some surprising implications for currencies.

Certain industries simply need to be nationalized. But for different reasons. Industries such as the auto industry, which is dominated by a handful of large companies and which employ large numbers of people, need to be nationalized simply to stem the lay offs. These industries are no longer viable in size but an instantaneous downsizing simply doesn’t work economically or socially. A gradual downsizing is only feasible under central planning.