Don’t feel compelled to buy stocks now.

Though the economic news lately has been “less bad” compared to just several months ago, the economy remains badly fractured and still heavily reliant on government life support. Several important credit markets are still largely dysfunctional and the entire yield curve on Treasury securities has surged since May making the prospect of recovery more uncertain.

The government is also in the process of revamping financial regulations and securities laws – similar to what occurred during the 1930s. This effort is laced with great uncertainty because nobody really knows how policy will affect the banking sector and the future of profitability.

Earlier this week, Dow Theory flashed a warning signal as the Dow Jones Transportation Average failed to confirm the Dow Jones Industrials Average – meaning, a major divergence has occurred in this market rally since March 9. Both averages must confirm each other if this is truly a new bull market.

I’ve argued all along that although March did represent a good opportunity to buy battered stocks, it wasn’t the bottom of this economic cycle. I remain adamant that the United States won’t muster a typical post-WW II expansion because of tight credit, tepid domestic consumption and rising unemployment. These trends have not improved over the last twelve weeks and challenge conventional wisdom surrounding “green shoots.” Basically, the government can’t act as the consumer of last resort through fiscal spending indefinitely; organic domestic consumption will remain impaired for years.

The markets gravely underestimate the effects of a severe credit-inflicted bear market with participants bullish on the economy and earnings without understanding the consequences of credit expansion or in this case, the lack of credit growth. Bank lending remains anemic and if it doesn’t grow soon the Federal Reserve will probably have to make loans directly to cash-starved companies and even consumers. That’s not the ideal macro scenario for a sustainable rally in risky assets.

Ahead of corporate earnings guidance later this summer, it’s hard to envision a swift earnings recovery. Investors have re-embraced risk all too quickly since March with emerging market stocks skyrocketing on the heels of a commodity recovery and the dollar heading sharply lower since May. Let’s not forget that companies will once again find $70 oil and possibly, $80 oil a major headwind to earnings growth.

Junk bonds, in the midst of a “bubble” ahead of almost $1 trillion dollars of refinancing coming due over the next five years are severely overbought considering where we stand in the credit cycle. Also, credit spreads for most emerging market bonds are ridiculously narrow --- barely 400 basis points above Treasury bonds. Some countries, like Brazil, are clearly in a “bubble” with everything Brazilian surging over the last seven years, including the real currency, bonds and the BOVESPA.

Markets are now obsessed with inflation – a monetary phenomenon that’s inevitable as a result of unprecedented fiscal spending and bank bailouts in the United States and Europe. True, inflation will make a violent comeback over the next 36-48 months as the United States attempts to print its way back to prosperity.

But there’s a problem believing inflation will rear its ugly head soon.

Several important indicators are NOT flashing inflation.

Of these, TIPS or Treasury Inflation-Protected Securities have declined over the last few weeks – a sign investors aren’t paying for inflation protection. Also, gold prices have declined about $60 off their best levels last month while wages are on the verge of turning negative. Finally, the Dow Transports should be hitting new multi-month highs if inflation and pricing power was truly making a recovery since this index is a leading economic barometer of cyclical expansion.

I’m sticking to convertible bonds, investment-grade bonds, TIPS, Canadian investment-grade debt and increasingly looking to add bear market indexes tied to junk bonds, emerging market bonds, stocks and the VIX. I hold little or no equities, except the biggest food and beverage companies, some renewable energy and gold stocks.

We’ve come a log way since March but investors have underestimated the economic environment – still heavily impaired by a lack of bank credit growth and poor loan demand. Inflation won’t grow under these circumstances and corporate earnings have little or no pricing power to justify current multiples, which by the way are not cheap after a 50% rally for the MSCI World Index since March 9.

Have a good weekend. See you on Monday.