Coming This Fall - The Best Time To Invest
Since April we have been laying out the case for the potential repeat of both 2010 and 2011 summer slumps. During the summer of 2010 the market sold off as QE-1 came to an end as the economy began to drag. As the summer of 2011 saw the end of QE 2, a debt ceiling debt and Greece on the verge of default which once again dragged the markets off their liquidity induced highs. Today we are in the dangerous months of July and August with the markets faced by many of the same challenges again such as:
- Another resurgence of the Eurocrisis
- Slowing domestic economics as witnessed by recent drops in manufacturing, employment and confidence reports
- A reduction in liquidity from the end of LTRO's and the majority of Operation Twist
- Earnings warnings and corporate profit concerns
- Another potential debt ceiling debate coming
- The concerns over the "fiscal cliff" at year end.
- Seasonal summer weakness
The chart shows an overlay of the April through August summer periods of 2010, 2011 and current to date. Just in case you have not noticed there is very little evidence of organic growth driving the current economy particularly in the macro sense. What is driving the market, more than anything else, are continued expectations for further intervention by central banks both domestically and globally. This no more evident than on Monday when following a very disappointing ISM Manufacturing Survey, which showed an outright contraction, that the market rallied on the belief that this would open the door for further stimulative programs from the Fed. However, why should this not be the case since it has been these injections of liquidity that have, for the previous two summers, been the primary driver for propelling the markets out of their summer selloffs?
The optimism for further Fed action at this point, however, may be premature. With the market currently only off its April highs by less than 4% there is very little benefit from launching further stimulative measures at the current time. The diminished return from each subsequent intervention leaves Ben in a position of needing the biggest "bang for the buck" from the next program which makes timing of such an intervention extremely critical.
This brings up the obvious question of what set of conditions are necessary to spur further action? The Fed has 3 basic requirements to launch additional balance sheet expansion programs:
- A stock market that has, or is, declining sharply and headed for levels that will impact consumer confidence.
- Subdued levels of inflation as balance sheet programs push commodity prices higher.
- An economic environment that is slowing towards recession.
The first issue is fairly easy to measure. The STA Risk Ratio is a composite indicator of several basic gauges of "investor fear" in the market including the VIX, New Highs vs. New Lows, the Rate of Change of the S&P 500 and two measures of bullish and bearish sentiment. When the ratio is declining it is a sign that "fear" is beginning to surface. A reading below "zero" is showing levels of extreme negative sentiment. Currently we are still at levels that show relative complacency in the markets although we are well off the peaks seen at the beginning of 2010 and 2011.
The second concern of the Fed, high commodity prices that impact consumer confidence and consumption, have been alleviated from earlier this year as they have declined sharply in prices from the first quarter spurt. With oil down to $85 a barrel from $110 this translates into lower gasoline prices at the pump which is an effective tax credit to the consumer. This gives the Fed some breathing room to implement a program without absolutely destroying the purchasing power of the consumer which makes up in excess of 70% of the economy.
Lastly, the economy has certainly slowed from its 3% pace in the 4th quarter of 2011 to just 1.9% in the 1st quarter of 2012. As we stated above the decline in economic growth is certainly troublesome and slate of weakness in recent economic reports does not bode well for a stronger second quarter report. However, 1.9% is not too far from the Fed's 2012 average benchmark estimation of 2%, as discussed here, so Bernanke will very much want to wait to see the first and second estimate for the second quarter of 2012. If the economy weakens to 1.5%, or lower, this will certainly give Bernanke an invitation to act.
The Best Time To Invest And Where
This is why we recently recently stated: " I do not think that we will see any action before the August-September period which we laid out in our recent PPI report: 'While there are many calls for Bernanke to announce QE at the June FOMC meeting, while possible, I think this is a fairly low probability event. Bernanke will likely wait to get a final read on first quarter GDP with some early diagnosis on 2nd quarter as well. With inflation taming, and the markets not absolutely collapsing at this point, my best guess is that he may hint at QE at the next meeting to gauge market response. As QE programs are highly inflationary he will likely wait until the end of summer, with a possibility of post election, to announce the next round of stimulative action. Make no mistake - there is no real organic growth occurring in the economy and no support coming from Washington. There will be further stimulative programs in the future — it is only a question of when.'"
Currently, with the markets on confirmed "sell" signals and a "major sell" signal approaching it remains to the benefit of investors to remain underweight equities, and primarily focused in lower volatility "blue-chip" dividend payers, and overweight fixed income and cash. The historically weak months of July and August are fast approaching and with no real catalysts currently available to push stocks much higher the risk remains to the downside.
If this summer continues to follow the last two, this is no guarantee - just an observation, then we would expect to see further deterioration in the markets over the next two months as the drag of weaker corporate earnings and economics take their toll. That decline will push the markets to an extreme negative reading that will be reflected in our "risk ratio" indicator at levels below "zero" and likely closer to -50.
Increased negative sentiment at these levels will combine with weak economics giving the "green light" to the Fed to take action to try to spark consumer confidence by increasing asset prices. A further balance sheet expansion program (QE3), which is supportive to the markets, will give investors the best opportunity to increase "risk" exposure later this summer. The best place to be invested for such an event will be:
The onset of further balance sheet expansion will also put the US Dollar under pressure and drive interest rates higher. Therefore, allocations to global bonds and foreign currency will also make sense.
The currently rally from June lows is a reflexive rally that has run its course. Use this rally to raise cash and lower risk based exposure to portfolios for the current time. This will put you in the best possible position to be a buyer at lower prices later this summer. If I am wrong and the markets continue to rally, eventually reversing all of our "sell" signals, then we will miss a small part of the rally. However, if I am right, the potential loss of investment capital will be far worse. Using rallies to make up lost capital is not a long term solution to investment success.