Are markets all over irrational again?

Warren Buffett?s recent planned $27 billion acquisition of Burlington Northern Santa Fe has been described as an ?all-in wager on the economic future of the US?. If the best expression of the future of the US economy is a railway operator dating back to the mid-1800s, then Mr Buffett?s (it is hard to contest Mr Buffett?s strategy as a means of accumulating long-term wealth, given that it has worked so well) judgement on the strength and prospects of the US economy appears less than sanguine.

With equities correcting over the last few weeks and gold rallying to record highs, price of gold has once again exceeded the price of S&P 500. It now takes 0.96 ounces of gold to buy S&P 500. This is considerably less than the long-term average of 1.74 since 1980, and a far cry from July 1999 when it took over 5.5 ounces of gold to buy S&P 500. The question now is, if gold eclipses 1,100, will its time above that level be as brief as it recently was for S&P 500?S&P 500 priced in gold:

Today, S&P 500 is priced for 4% real economic growth in the coming year. In contrast, the corporate bond market is now priced for 2% real GDP growth, not 4%. In other words, there is less risk in credit than there is in equities, even after corporate spreads have been sliced in half from their depression-era levels.

The dollar slump has to reverse: Last year?s dollar slump, with its attendant rise in commodity prices, ended when the market put paid to it. This time governments are attempting to slow it down. Canada?s central bank recently talked down its own currency, Brazil?s government has imposed capital controls to stop the Real gaining at the dollar?s expense and Taiwan?s central bank is believed to be preparing to intervene since flows of speculative ?hot money? have made the rate too volatile. Other countries, it appears, have more to lose from a weak dollar than the US does. Once the fall in the dollar index reverses, so will the renewed rise in commodity prices. Energy stocks and commodity prices along with trash stocks (banks like Citi and AIG in the US, and real estate stocks in India) have been at the vanguard of the recent stock market advance.

Trailing valuations of emerging markets are the highest in almost a decade: Bonds show a similar exuberance. The excess yield over US Treasury notes in the benchmark EMBI + Index is now about 320 basis points, less than just before Lehman?s collapse. Since financial markets? nadir in early March, a Brazilian 10-year sovereign bond has seen its yield drop 208 basis points even as the US 10-year note?s yield has risen 52 basis points.

Relationships between markets imply unhealthy levels of speculation: In quantum mechanics, so-called superposition is when something exists in two or more states at the same time. These days, the same seems true across economies and financial markets. Investors? diametrically opposed views on everything from prospects for growth to whether there will be inflation or disinflation are resulting in simultaneous rises in usually opposing types of assets.

Currency and stock markets had minimal correlations before the crisis took hold in 2007, while oil and stocks were usually inversely correlated. But oil and stocks have been rising in tandem this year, while the correlations between the dollar and stock markets remain remarkably close (negative since 2007).

Gold prices normally thrive in times of great uncertainty. However, prices of gold and stocks have been simultaneously rallying for most of the year, indicating one of the two economic scenarios being factored in is imperfect.

The return of ?carry trade?: The Fed has been injecting liquidity into the monetary system to stimulate lending. However, banks find it difficult to lend this money in the current environment. Banks have the option of putting this money at the Fed at 0.25% (on excess reserves at 0.15%) or invest it in assets providing better returns.

This money finds its way to equities, corporate bonds, US Treasuries and commodities. A good amount of that money also gets invested in the excess-liquidity carry trade.

What is more, if carry trades are the rage again due to animal spirits, why is ultra-safe gold at an all-time high? The yen and Swiss franc, traditional borrowing currencies, are also rallying.

Perhaps investors reckon they are onto a sure thing. And we all know?there is no such ?sure thing?.

Stock and commodity traders are borrowing at negative 20% interest rates (the fall in the US dollar leads to massive capital gains on short dollar positions) to invest on a highly leveraged basis on risky assets that are rising simultaneously?stocks, bonds, oil, gold and other commodities.

Many asset prices now seem to be extremely dependent on the glut of cheap liquidity that comes from the dollar carry trade; if you look at the chart of the dollar/emerging market exchange rate against the MSCI emerging markets index this year, the correlation between the two is very striking. The implication is that if the dollar rises and carry traders bail out of their assets again, we?ll probably see another sharp global sell-off in all assets.

Not a value-based stock market rally: Expensive stocks have beaten cheap stocks by more than 10% since May, their most significant outperformance since markets rebounded after the tech bust in late 2002.

In the past, such outperformance has been a good warning sign of a bearish market or correction to come.

During the boom years, the wellbeing of the economy depended on the rapid growth in household credit. The current recovery is founded on the even greater expansion of government liabilities. Net government borrowing climbed at an annualised rate of $2,000 billion in the second quarter. Sooner or later, this fiscal economic prop must be removed. Only then will we know for sure whether the current turn in the cycle resembles a rubber ball recovery or a dead cat bounce.

Inflation all set to return with a vengeance: In this month?s survey, respondents to the ISM Survey saw price increases in 11 commodities and decreases in only one. This month?s net reading of +10 brought the three-month moving average to 11 and it is at the highest level since September 2008.

The chart here compares the three-month average net reading in the ISM Commodities Survey (CS) with the year-over-year change in CPI. Over the last ten years, trends in the CS have often preceded moves in the CPI. So when the net reading in the CS rises, increases in the CPI are typically not far off. Therefore, given that the net number of commodities rising in price is currently at +10 from a low of -15 in February, it is likely that upcoming inflation reports come in on the high side of expectations.

World of contradictions: Those who believe that the worst is over have happily been buying equities since March. They are also pushing oil and commodity prices higher, expecting global demand to recover to pre-crisis levels reasonably quickly. At the same time, for opposite reasons, doom-mongers are piling into bonds: yields on 10-year Treasuries have fallen 10 basis points in the past three weeks and the only US mutual fund net inflows have been into fixed income funds this year. Mixed interpretations also abound in currency land. Buoyant traders wanting risk are loving Australian dollars and Brazilian Reals. But safe-haven currencies such as the Japanese yen are rallying as well. Likewise, gold investors are schizophrenic; encouraging signs and negative news both seem reasons to buy. And gold recently touched record levels in nominal terms, while relative movements of inflation-linked bonds suggest other investors think prices are heading south.

The parallel universes existing in the world today merely reflect the inconsistency of fundamental data. Why are US retail sales improving while unemployment and foreclosures continue to rise and consumer credit is shrinking? Export-heavy nations such as Germany are recovering just as their currencies are getting more expensive. Dodgy emerging market sovereign debt or US municipal bonds are priced as if riskless.

As the dust settles, only one interpretation of the world will prove correct. Markets can remain irrational for a long time but the reality check will be brutal for some.

?The author is a Wharton Business School MBA, and CEO, Global Money Investor