Author: Brad Pappas, Rocky Mountain Humane Investing
Covestor model: RHMI Evergreen
Disclosure: Long GLD
One of the most frequently posed questions is “What’s keeping you up at night?” It doesn’t take much when you’re the father of teenagers. On the investment side of the worry list, we’ve already been through a lot this year from the tremendous earthquake and tsunami in Japan to the budget / default issues plaguing Greece and much of Europe. The disaster in Japan alone could have cost as much as one percentage point to our second quarter GDP. Much of this was related to auto manufacturing and most of it was very quietly handled as no one wanted to admit to gaps in the supply chain. One the bright side, the Japanese caused slowdown is in the past and a resurgence of Japanese activity is at hand.
The second quarter of 2011 was fairly rough and our portfolios gave back much of the gains from January to mid-February. My view has been that the market weakness which began in the latter half of February is likely to have been an ordinary, garden variety market correction which is a necessary evil and not the start of a severe bear market in stocks. The primary warning signs associated with severe bear markets are not currently present: inverted yield curves, sharp increase in junk bond yields vs. Treasuries or significant earnings estimate declines. With growth slowing in the US and worldwide as of May, it’s easy to be thinking with a negative bias, but we’re not going into recession yet , while virtually all consumer and investment sentiment indicators show that our current risks are well known at this point.
The most recent market pullback and investment fears are reminiscent of last summer’s economic soft patch, with threats of deflation – but with two differences. One: the Japanese disaster, which interrupted the flow of manufacturing especially of autos. Two: recognition by investors of the inept and partisan politics of our political leadership. Many believe our economy will stage a modest rebound in the second half, primarily due to Japan coming back online.
While the primary second quarter trend was down for the markets, it appears the selloff has been contained. The correction was enough to eliminate the excessive bullishness that had built up from the previous rally. In the short term, market direction is anyone’s guess, but I envision a trading range for the next quarter.
Despite the soft patch of economic weakness, the guiding indicator to our investment exposure remains positive and a recession is unlikely at this point. While forward earnings expectations for the S&P 500 index constituents peaked in June, the ensuing slowdown has been very shallow and not enough to endanger the present bull market.
One of the biggest changes we made to portfolios in the second quarter was the sizeable addition of gold (via SPDR Gold Trust (ETF) (NYSE: GLD)). Gold acts more like a currency nowadays rather than a commodity. Should the Dollar or Euro recede in value investors will likely continue to look to gold and the Swiss Franc as a haven against falling USD and Euro. With this latest bout of economic weakness I don’t believe there is meaningful upside to owning Treasuries or high yield, but with the debt crisis in Greece, Italy, Portugal and Ireland not to mention the US there is I believe, a valid case for owning gold and the Swiss Franc as a hedge against calamity.
What is especially intriguing about gold at the moment is the current significant negative sentiment towards the metal. Typically, I’d expect that sentiment to be quite positive since it’s trading so close to its annual high, but sentiment is actually quite negative. Sentiment is a reverse indicator – the worse the sentiment, the better the prospects.
Sad to say, our politicians appear to be more concerned with entrenched policies and kicking the can down the road than dealing with the issues head on. It appears incredibly frustrating to solve our economic issues when one party benefits from failure and fear. Austerity measures such as budget cuts and higher taxes add a further burden to the economy. It will take several years for the debt burdens to be processed and I do envision a severe bear market within a year or two, especially when the US must face reducing the deficit without the benefits of Treasury support such as what we experienced in the last year with Quantitative Easing.
The Republican approach of reducing taxes aka Trickle-Down Economics as a spur to the economy is flawed since corporate balance sheets are excellent and despite their liquidity, corporations have yet to hire new employees. Whatever happened to the “green shoots” of tax cut benefits? Obviously, the Democrat’s approach has not been a boon for prosperity but the measures taken by the Federal Reserve in the last three years prevented a Depression and 20% unemployment.
Gun to my head for what the future holds? It’s a mixed bag for the next 5 years or so, nothing new about that. Politicians can kick the can down the road for quite a long way before finally tackling the issue. I think it’s inevitable that Greece, Portugal, and possibly Italy/Ireland default but I don’t believe it’s imminent nor will they be the cause of a Bear Market, it’s much too easy and telegraphed to assume so for my liking.
My belief is that the fragile expansion will eventually give way to a second recession caused by government policies including debt reduction which would cause a bear market. The focus of what appears to be a daily crisis – default of the PIGS (Portugal, Italy, Greece and Spain) – will likely be the finale of the bear market, just as the fall of Lehman marked a selling climax in 2008. Once this purge is completed, it’s possible that a new secular bull market in stocks could begin, a move lasting 15-20 years. Gold may be the single best asset class should a full blown currency crisis emerge.
All the best,
Brad Pappas
