4-Issues For The Market Ahead
We have been discussing the confirmation of our "weekly" sell signal and the implications of lower market levels in the coming weeks and months ahead. It is important to distinguish that the analysis was not designed for short term traders but rather longer term investors and portfolio managers who are more concerned with changes in market trends. As longer term investors it is a balancing act between the technical price movements of the market itself and the global macro outlook. Since we have already defined our technical analysis of the current market environment it is important to marry our global macro outlook and the potential headwinds to support our assumptions of a tougher market environment this summer. The following is my top 4 list.
The possibility of an exit from the Eurozone by Greece has risen markedly in the last few days. The specter of such an event leads to many uncertainties from the stability of the financial system, potential further default issues and the impact to the Eurozone economy as a whole.
As we have previously discussed, the problem is that austerity and economic growth are diametrically opposed to each other. It is like trying to lose weight by eating more. A major concern is the newly elected socialists in Greece and France which have vowed to keep their pre-election promises and increase socialism. The reality is that the dark side of socialism (confiscatory taxes, redistribution of wealth, more debt, more government intrusion and central planning) trumps the expedient benefits of deficit spending when sovereign debt and banks are at the abyss.
For Germany it is a critical point. The ability to work with France is rapidly deteriorating. Berlin has put off hard choices since the crisis began. It has refused Eurobonds or budget transfers, stepping back from the Rubicon of fiscal union. Angela Merkel has insisted on austerity and reforms alone, imposing the full burden of adjustment on the weaker states. If Germany does move ahead with more funding of the EU it will most assuredly lose its AAA rating. That will mark the end of the EU as there will literally no longer be a AAA rated entity large enough to fund additional bailouts.
For the financial markets the uncertainty of the impact to both the financial system and the future of the Union itself will continue to roil the markets. If Greece leaves the Euro it will just be a function of time before Spain or Italy default or threatens to leave as well. Germany and France will continue to stalemate any ability to make progress which will lead to further financial strains and market distress.
The reality is that there is not enough money to fix the Eurozone problem. There is too much debt and leverage and not enough growth to reverse the balance. If a systemic "run on the banks" occurs the impact to the U.S. financial system will be dramatic. The possibility of a second financial crisis, both domestically and globally, is a very real possibility. This is why the G-8 summit was focused on more bailouts, inducements and spending in order to the keep the Eurozone afloat. Unfortunately, the end result will still likely be the same.
2) Fiscal Cliff
Early next year income taxes are set to rise as the Bush-era tax rates expire, the automatic spending cuts triggered by last August's debt-ceiling deal will hit and payments to physicians under Medicare will be slashed. All of this will result in roughly a 4% hit to domestic GDP. With GDP currently growing at roughly 2% it is simply not strong enough to sustain the impact of demand cuts caused by increased taxes and spending cuts.
While the CBO is currently projecting that the gross domestic product (GDP) will contract by 1.3 percent in the first half of 2013 it is likely to be even worse than that. "Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession," the report states. This is the first time CBO has forecast a recession resulting from the fiscal cliff as in just this past January their estimate was for a 1.1 percent GDP growth in 2013 if policies are not dealt with.
"It's very important to say that, if no action were to be taken by the fiscal authorities, the size of the fiscal cliff is such that I think there is absolutely no chance that the Fed could or would have any ability to offset, whatsoever, that effect on the economy," Bernanke told reporters in April. "I am concerned that if all the tax increases and spending cuts that are associated with current law would take place, absent congressional actions, that would be a significant risk to the recovery."
The market, however, is unlikely to wait for the fiscal cliff to occur before making price adjustments Considering the political headwinds that currently exist the likelihood of getting the two sides of the isle to work together is hardly likely. The resulting negative rhetoric is likely to place further pressure on the market in the short term. Ultimately, the automatic spending cuts will be set aside and the tax cuts and credits will likely be extended. However, that resolution will likely not occur until after the next election which, by that time, much of the damage to investors will have already been done.
3) Debt Ceiling Debate
It is amazing that just last summer we were facing the same dilemma that is rapidly approaching. As the national debt continues to rise as government spending continues in its unbridled fashion the "debt ceiling" is rapidly approaching. At the current rate of growth of the Federal Debt the debt ceiling will be obtained by Labor Day.
While there is absolutely no chance of default on U.S. debt this will be the point that the administration tries to use to gain leverage for another, and inevitable, increase in the debt ceiling. This "fear" of default was one of the primary reasons, beside the Greek crisis and end of QE 2, for the near 20% decline in the markets last summer. This occurred even as interest rates fell to the lowest level on record at that time signaling the bond market had no fears of a potential default. The American people were duped.
The issue of the debt ceiling debate is more grandstanding and arm twisting versus a real issue to the financial markets. However, the "fear mongering" does have a negative impact on investor sentiment. When that negative sentiment is combined with a potential Greek crisis and contraction of liquidity, as "operation twist" comes to an end, it is a perfect recipe for a market rout.
4) Weakening Economy
The economy remains at a sub-par growth rate and is very subject to external shocks. Whether it is the impact of a burgeoning Eurocrisis or rising taxes the reality is that the growth rate is too weak to amply absorb any offsets. With more than 71% of the economy currently based on consumption the impact to the consumer through rising taxes, lower wages, increased unemployment or higher food and energy prices are translated quickly into the economy.
The economy picked up post last year's debt ceiling/Greek crisis fiasco as the drop in oil prices and unseasonably warm weather gave consumers approximately $90 billion in effective tax credits which helped fuel consumption through the end of the first quarter of 2012. However, in recent economic reports we are already witnessing the decline in economic strength as weather patterns return to normal, rising gas and energy prices in the first quarter are translated into early second quarter readings and the psychological impacts of geopolitical and financial events takes hold.
All four of these headwinds loom large in the coming months ahead. When combined with our recent technical "sell signals" it is a recipe for weaker stock market prices. Therefore, we are now in a position of changing our investment strategy from "buying dips" which prevailed since last October to "selling rallies" in order to reduce equity risk and raise cash to protect portfolios.
How To Position For A Turbulent Summer
This summer is set up to be as sloppy as the previous two. The recent sell off in the market is overdone on a short term basis and with weekly technical sell signals currently in place the easiest path for the market at this point is to the downside. Therefore, raising cash to hedge portfolios until the next "buy signals" are generated is recommended.
- Liquidate weak and underperforming positions as the market approaches the 1350 and 1360 levels.
- Rebalance winning positions by taking profits and resizing positions back to original weights,
- Look for rotation into precious metals as a "safe haven" investment which are currently very oversold and holding support. (We are currently long GLD and GDX)
- Short duration fixed income is still an alternative to "money markets" as rates will likely remain under pressure as rotation out of stocks continue.
- Our call to buy bonds over the past month has played out well. They are currently overbought and extended. Hold current positions but be selective on new additions at this time. Wait for a move in interest rates to 2.2% on the 10-year treasury before aggressively adding more
- Be careful with dividend yielding stocks — while they will likely hold up better during a market correction they are already overbought in many cases. Sometimes "cash" is a better alternative for protecting portfolios versus "less of a decline"."
- Hold cash for the next "buy" signal becomes apparent.
The next few months heading into the political election are likely to be fraught with volatility, uncertainty and fear. There is currently little question that the Fed will intervene at some point soon with QE 3 as there is little evidence that any assistance will be coming from much of anywhere else to support the economy. The potential collapse of the Eurozone and the impact on the financial system will reign supremely in the coming months which is why it will most likely pay for investors to remain more cautious.