In January, a troika of worries knocked down the market: credit tightening in China; regulation in Washington; and sovereign debt problems in Europe, and particularly in Greece.
- the long-term view – Greece is a small percentage of European GDP – about 2.5%. It won’t go under, they’ll fix it, all the market hoopla is just noise. Use the dips as an opportunity to buy. Many long-term fundamentalist and value players are in this camp.
- the contagion view – where there’s one cockroach, there’s more. Greece is just the first in many, Portugal, Ireland, Iceland and Spain are next (the PIIGS countries). Credit default swaps (CDS) prices are exploding (this is the cost of insurance on debt), this is just like Lehman Brothers in 2008. Get out of the market and stay out. Many traders are in this camp.
- the macro bull – this point of view says, we’ve been up huge in 2009. It’s about time for a correction. We’ll correct 10-15%, and then we’ll resume our upward path toward recovery. Ride it out, we’ll be up by the end of the year.
- the macro bear – this view says that it’s just the beginning of the second half of a double dip. Stimulus is being withdrawn around the world, and we’ve got nothing but problems ahead of us: more real estate losses; consumer is dead in the water; productivity is up but demand is not; unemployment remains high. Sell and put your money in cash or short term bonds.
These perspectives are all over the map. Is there a right answer? Is there a best course of action? If there is, it’s not clear by any means. And truth is, several o f these views are correct – depending on what your time frame and your risk tolerance is.
Let’s start with the hold approach. Truth is, this will all blow over – eventually. But that “eventually” could be a long time from now, and in the meantime, your stocks could be down 10-15% from where they were in January. As of today, the S&P is down 5.2% year-to-date (the S&P was 1,115.10 on 12/31/09; today it’s at 1,070.52) and 6.9% off the year-to-date high of 1,150.23 recorded on Tuesday, January 19, 2010. Being down can be no fun; handling it takes a strong stomach and lots of patience.
For me, the other problem with the hold approach is that it’s a bit simplistic and could lead you to ignore several fundamental changes in the market. Last year, a weak dollar led to a strong dollar, a rally in commodities and rising gold. This pattern, which governed trading in 2009, no longer applies. Now, we have a different set of relationships in market:
- With problems in the Eurozone, capital is moving into dollars for safety. This causes the dollar to rise and the Euro to fall. If you think about it, there’s really no where else to go; Asian, Latin American and Russian currencies are all worse choices.
- The rising dollar means lower commodities prices, because commodities are traded in dollars. This explains the fall in commodities investments, and implies that you should stay out of commodities as long as the dollar is rising.
- The rising dollar also means an unwind of the carry trade. Because the US has near zero interest rates, money was borrowed in US Dollars and financed investments around the world. As the dollar rises, borrowing becomes more expensive because borrowers have to convert back to dollars to repay their debt. A rising dollar forces the borrowers in the “carry trade” to sell off their stocks and repay their US Dollar obligations before their debt becomes more expensive. For now, the rising dollar puts selling pressure on stocks.
- Finally, the rising dollar causes the price of gold to fall. Gold is intricately linked to currency movements and rises in two scenarios: when major such as the US Dollar are low and declining, because gold becomes a greater store of value than the currency; and when there’s inflation, because again, gold becomes a better store of value. So as the dollar rises, it becomes a better store of value relative to gold, causing gold prices to fall.
As you can see, these are major trend reversals, and has significant implications for investing. These relationships affect a number of stocks, so it’s not at all clear that you should hold on to all stocks as these relationships shift.
The sell approach has its advantages and challenges. First, if I can spot the decline, I’d like to avoid as much of the 5-7% decline in the market as much as possible. And keep in mind, some sectors are already in correction range, well in excess of a 10% decline. So if you hold such sectors (commodities, financials), selling would definitely save some red ink. If I can’t spot it, it’s not terrible, but it does mean looking at significant pullbacks in your positions for a while.
The next challenge is, when to buy? And should the money be re-allocated into different investments?
Unfortunately, we are likely to face a choppy period, governed primarily by a downward trend. Consider the European sovereign debt situation. Today, the market rallied because it seemed likely that some kind of bailout for Greece was forthcoming. If so, we will rally. Still, it will not be long before investors start to pressure the other European weak links – Portugal, Iceland, Ireland and Spain. So we’ll have more market retreats sparked by European debt fears. Meanwhile, the Euro should continue to decline, and the dollar should continue to rise. Because this will continue for some time, there is no clear “re-entry” point for buying stocks. There’s no clear case for saying that current market levels will hold; any one of these alarms could send markets below today’s levels.
As for the re-allocation question, this is a key consideration. The relationships described above imply the following:
- commodities will remain under pressure, especially if more bad news comes out of China (such as further credit tightening)
- gold will be limited by the rising dollar
- long dollar, short Euro – this is basically the trend for both currencies so long as Eurozone problems are at the forefront
- equities as a whole will remain pressured by the continued unwind of the carry trade. At some point, traders will find another source of funding, but that will take some time
- financials tend to be pressured by sovereign debt fears; as long as these continue, financials will be under pressure
- cyclicals should also be pressured as economies around the world retreat. It’s now a fair question whether 2010 earnings targets will be achieved.
- long short-term Treasuries in the near-term. When fear grips the markets, investors want dollars and US Treasuries. The short end of the yield curve is the favored place to put money in times of stress. The longer end of the yield curve is problematic because European debt now sells for higher yields, and will have a bit of a spillover effect for all. Also, all countries are withdrawing stimulus and tightening credit, which will cause the longer end of the yield curve to rise.
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