The head ruling the heart.

My old friends on Wall Street,now occupying frighteningly senior positions, continue to tell me that the rally in equity (and other) markets will continue through to the end of the year. Institutional investors are still relatively underweight equities and the higher the market goes the greater the peer pressure to join in. End of story as far as they're concerned.

The bottom line is that my worries about the health of bank balance sheets or demand for IT products should be set aside for another day. Isn't it galling to have been so right on the way down and so out of kilter on the way back up?

Although clearly wrongfooted by the extent of the rally I'm still not converted to the longevity of this bullish world view. I still cling to the belief that my realistic (some would say negative) stance on the global economic outlook has some basis to it. Banks have led the markets surge higher but strip out one-off gains and frenetic investment banking and you're left with a sector that's enjoying a relief rally thanks to the tax payer. At what stage does a relief rally become froth? Ditto the autos who have enjoyed their time in the sun due to 'cash for clunkers'. When that boost evaporates at the end of the year their revenue streams might again appear exposed. As for IT the consumer credit environment doesn't look any rosier than it did six months ago. Certainly, the airlines are not seeing any sustainable signs of an upturn in either leisure,or more worryingly,business traffic. A harsh autumn awaits them.

Putting it all together it looks as though we're past the worst. Some see bright sunlit uplands ahead whereas I see limited recovery, government budgets stretched to breaking point, and the growing eventuality that stimulus packages are going to have to be reduced (if not reversed). I'm more than happy to stick to those sectors that are lagging behind - ie those enjoying strong demand, high visibility of earnings, and predictable and conservative cahsflows. Undervalued equities have been and always will be attractive. Cyclical stocks (now on PE's of nearly 30x) have been where the action is but from a UK perspective the latest 18% fall in domestic business investment and the biggest decline in commercial credit since records began doesn't seem to be a benign backdrop.I'll put the markets recent enthusiasm down to institutions being dragged back into the game and to a large number of commentators whose heart is ruling their head - a view reinforced by an article saying that day trading is reaching levels not seen since the glory levesl of the dotcom boom.

Sentiment heads south.

Markets seem to be coming round to the view that we are in this for the long haul and that the 'green shoots' are going to grow at a rather leisurely pace rather than at the vigorous rate that so many have been anticipating. When the SPX gets well below 800 I'll start to look at stocks again.

Over dinner a few nights ago a neighbour suddenly launched into an impassioned attack on bankers, greed and the need for much tougher regulation of the financial industry. It suddenly struck me that the call for additional oversight ,although popular, if badly handled might make matters worse- possibly much worse.

Anyone who has ever had to deal with the FSA or SEC over the last decade will know that this economic crisis did not occur because of lack of regulation - these august bodies already had vast armies of people, a record number of regulations,and near unlimited powers. Now , the regulators want even more powers and want the banks to raise more capital,lend less and impose tighter controls.

In a world where credit is evaporating , capex is shrivelling and where factory utilisation numbers are dismal (65% in US manufacturing) this enforced shrinking of capital is the last thing we need.With US and Euroland banks needing to write down another $1 trillion or so over the next couple of years governments are talking about imposing what looks like regulatory and economic idiocy. Why not simply go back to the good old days of partnership structures and unlimited directors responsibility? I'm all for sensible targetted regulation but hastily drafted rules might end up proving to have dire,and unintended consequences for the broader economy.

BA,SAS,Swiss still in the midst of the storm

Markets have continued to drift gently higher since I last wrote - proving my upside market sense and timing to be out of step with prevailing sentiment . After the sharp increases of April and May which gave us the strongest bear market rally in history, there seems to be less conviction that the equity rally has much further to go amid signs that interest rates in the UK and US might have to reverse course and move higher. In the broader economy it's interesting to note that:

• Irish prices fell by 4.7% in the year to May - the steepest fall since 1933
• US household net worth ( including real estate,stocks, and bonds ) was off $14 trillion from its 2007 peak
• US May retail sales were off 10.8% from year ago levels - gas station sales were down 33.8% and car dealership sales off 19.6% from prior year levels.

I keep on looking for signs of 'green shoots' in the airline industry but all I see so far is proliferating weeds. If I could discern that corporate or vacation passengers were returning to their established travel plans then I would feel much more confident that we had hit a low point from which the economy was set to recover. In the airline sector, like the auto and banking sectors we are just beginning to see that consolidation and capacity reduction are needed to remove chronic over supply and restore profitability.

IATA has said that the worlds airlines are seeing few concrete signs of recovery and many of them are at a knife edge. Yields are crumbling and losses are widening at a hectic pace. IATA also revised its forecast for industry losses in 2009 to $9 billion a doubling from its forecast of $4.7 billion made just two months ago. After September 11 airline revenues fell by 7% and it took three years to recover. This time round revenues are down by more than 15% and the demand side is showing little sign of improvement.British Airways CEO says the carriers business faces 'serious threats' while Aer Lingus managements says this is the most difficult environment in its 73 year history.

• May 2009 Air France-KLM y-o-y passenger numbers down 7.8%. Asia Pacific down 10.9% and Trans-Atlantic down 9.3%.
• May 2009 SAS Group y-o-y passenger numbers down 17.1%.
• May 2009 SkyEurope passenger numbers down 37.5%
• Swiss CEO says that premium passenger and cargo demand has stabilized at a very low level and that prospects of a recovery this year are unlikely.

From the perspective of the airlines this economy ain't on the mend and higher fuel and financing costs aren't going to make it any easier to make a profit let alone survive. I'm told that Uniteds order for 150 new planes is dependent on the manufacturers finding the financing! I think we will avoid a depression thanks to government largesse but consumer expenditure hit by higher taxes,higher borrowing costs and higher unemployment is going to take a long time to recover. This now becomes a stock pickers market with sectors where demand is little impacted by a huge downturn in credit looking attractive no matter what happens to the broader indices. Pharmaceuticals fit the bill, as do restructuring plays, consolidation candidates, agriculturals and some precious metals.