Montreal, Canada

Bull markets might climb a wall of worry. But this rally is defying reality as it pertains to corporate earnings, domestic consumption, tepid bank credit expansion and surging long-term interest rates. The market is now more dangerous than at any other time since late 2007.

The biggest fear right now is the big move in long-term Treasury and mortgage rates.

The spike in yields is killing an already heavily leveraged economy in the process of recovering. Refinancing activity is now falling off a cliff again. At J.P. Morgan (quoted in today’s Wall Street Journal), “refinancing activity is already really down since rates began rising. A rate of 4.75% seemed to be the switch that turned on refinance activity.” The rate on 30-year fixed-rate mortgages is now at 5.78% this morning – up from 5% just two weeks ago.

By the way, foreclosures continue to hit records through April – and May won’t look any better as mortgage financing has plunged again amid soaring rates. Basically, housing hasn’t bottomed.

Yet the stock market is watching a different movie and it’s bullish…

Since the intermittent lows of March 9, risk-based assets have progressively rallied with some indexes breaking above important 200-day moving averages recently. Two weeks ago, the S&P 500 Index crossed its 200-day moving average – typically a bullish signal.

Unlike previous bear market rallies since October 2007 this one admittedly looks much brighter with liquidity returning en masse into several important credit markets and speculative bond yields plummeting. LIBOR rates have also plunged, corporate investment grade credit spreads have declined and investors are finally leaving the low-to-no-yielding sanctuary of money-market funds for stock funds since May.

Over the last three months the S&P 500 Index has surged more than 41% and the MSCI World Index has gained 34%. High-yield or junk bonds have rallied more than 35%, including interest income. Just about everything with a risk bias has skyrocketed since early March – including some mind-blowing gains in the emerging markets. I find the latter development especially odd since a chunk of this index is insolvent; banks in Eastern and Central Europe are largely bust and there remains the real possibility of a default in the Baltic Republics, namely Latvia.

So is this really a new bull market? If the Dow Jones Transportation Average closes above 3,404.11 then, according to Richard Russell (Dow Theory Letters), we’ve got a significant reason to be less bearish. That index would confirm the rising trend of the Dow Jones Industrials Average.

Even if this is a new bull market, I’m largely avoiding common stocks because risk is high and values are now scarce. The only stocks I like are the food and beverages like Néstle, Kraft Foods and McDonald’s.

The parallels between this credit crisis and the 1930s is close enough to warrant extreme caution; banks are still not lending, the Fed has not disengaged from several infected credit markets and the consumer isn’t spending in an environment of balance sheet repair and rising job losses. It’s naïve to believe China alone can save the world economy.

It’s just too risky to buy stocks here. At the very least, I’m compelled to wait for a pullback this summer and then add to some equity positions. But not at these levels.

Instead, I’ve been accumulating convertible bonds, investment grade corporate bonds and,recently, natural gas where the gas-to-oil ratio now stands at its widest since 1991.

We’ve possibly seen the lows in 2009. The amount of money being thrown at the financial system and into the real economy has been enormous – about $4.5 trillion in the United States alone.

Still, I’m looking carefully at the big spike in long-term interest rates and I don’t like what I see. I remind myself that we’re living in uncertain economic times and that this is a new world since 2007.

Investors seem to be lunging after risk again like its 2006 or Party Time, hopelessly relying on government to boost domestic consumption and sustain this bourgeoning recovery. Not me.