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Random Observations and Rising Risks

  • Written by Syndicated Publisher No Comments Comments
    April 19, 2013

    I have spent to last few days reviewing, writing, and discussing the economy, markets and investing.  While my opinions have been unfavorable amongst the many ‘stock bulls” over the last several months many of the issues I have been discussing, the ”risks”, are now coming to fruition.  My analysis is often misconstrued to mean ”get out of stocks and hide in cash” which could not be further from the truth.  As investors, and primarily savers, our job is simply this:

    “The allocation of capital with the least amount of risk to achieve a rate of return equal to the rate of inflation over time in order to preserve the future purchasing power parity of our savings.”

    Wall Street, however, has distorted that investing responsibility by turning the financial markets into a casino by chiding unwitting individuals to heavily speculate with their savings in a game they have little chance of winning over the long term.

    This is why I view my job, as lonely and as unfavorable as it is, to point out the risks that could possibly lead to large drawdowns of allocated capital.  “Risk” is not a function of how much you will make when the market rises but rather how much you will ”lose” when things don’t work out as planned.  The mainstream market analysts and economists are always optimistic with “your” money because as long as you are invested “they” make money.  Being in “cash” is not optimal for Wall Street because it reduces fees and commissions.  This is why you are told to “buy and hold” and “invest for the long term” yet there is not ONE successful hedge fund manager, trader or investor that has ever followed those rules.  Why is that?

    This leads me to a couple of rising “risks” that I have been discussing in the past and watching develop.

    Resurgence Of The Eurozone Crisis

    There is a widespread belief that in 2012 the ECB (European Central Bank), and it’s head Mario Draghi, effectively solved the Eurozone crisis with Draghi’s famous ”do anything” speech.  Unfortunately, all the speech did was tell financial institutions that no matter how much risk they took buying bonds of broke governments the ECB stood ready to bail them out if there was a default.   This is exactly what happened and borrowing rates fell for the most bankrupt of countries in the Eurozone.  However, nothing in terms of real financial reform, deficit reductions or spending cuts were implemented.   The reality is the Eurozone, in its entirety due to a spreading recession, is in its worst financial condition ever.

    The problem for the ECB is the upcoming elections in Germany.  As I wrote in August of 2012:

    “As we have discussed previously in much more detail - Germany is the paymaster in Europe and with a large majority of the German population against further bailouts, and Merkel up for re-election next year, it is likely that the things will not work out for Draghi as hoped. This will lead to a resurgence of the Eurocrisis, promptly to be followed by more talk and rhetoric, which will lead to concerns about a financial crisis spreading through the financial system.”

    I see that my concern from last summer is now taking root as Merkel was forced to rely on opposition votes to pass the Cyprus rescue package.  This does not bode well for her upcoming election this September and she has “bet the farm” with this recent action for her political future.  I have stated many times previously that there is a groundswell of voters that are beginning to push back against Germany’s continued bailouts of broke countries and the German Anti-Euro party is continuing to gain in popularity.  If Merkel loses in September’s election and the opposition gains control the risk of resurgence of the Eurozone crisis increases dramatically.

    The problem for the financial markets is that if Germany backs out of the “paymaster” role for the Eurozone the ECB effectively loses control of being able to honor its commitment of“doing anything” to keep the Eurozone afloat.  It is very likely, at that point, that the fabric of the Eurozone will tear and credit risk could spike sharply leading to a freeze in the credit markets on a scale larger than what was witnessed during the 2008 financial crisis.

    Leading Economic Indicator Growth Rates Deteriorates Further

    I have discussed recently that the peak of economic activity was seen in 2011-2012 and has been slowly deteriorating since.  The impact of this, of course, is that despite the Fed’s continued liquidity driven interventions the economy is no longer responding to such stimulus.  Asset markets have surged as liquidity has been dumped in but higher stock market prices isn’t translating into higher levels of consumer confidence or economic growth.

    The latest release of the LEI confirms the same by showing deterioration in the major economically sensitive areas such as building permits, factory workweek and a rise in unemployment claims.  The leading credit index ticked up which is a positive for the index but really shows that consumers are having to turn back to credit to support their living standard.  While leading credit has ticked up, wages and consumption have ticked down showing that consumers are spending more to buy the same or less goods and services.  This doesn’t bode well for future economic activity.   However, this is also why the coincident to lagging indicator ratio, which is like a book-to-bill ratio for the economy, has slid to its lowest level since the last recession and is well below levels normally associated with the onset of a recession.

    LEI-Coincident-To-Lagging-041813

    Two of the largest weighted factors in the LEI are the credit spread and the S&P 500 index.  These two components heavily influence the overall index AND are the two that are the most influenced by the Fed’s artificial interventions.  The yield spread is large because of the Fed’s suppression of the overnight lending rate and the S&P 500 index is much higher than it would be without ongoing liquidity injections.  Therefore, the reality is that under normal conditions the LEI would show a far weaker result. However, even with the Fed’s artificial supports, low interest rates should stimulate demand for borrowing, however, there has been relatively shallow demand for credit as the economy, particularly end demand, remains weak.

    Furthermore, the recent weakness in the stock market combined with further weakness in permits, employment and consumer expectations, will lead to further weakness in the April LEI release.

    The chart below shows the annual rate of change in the LEI index versus the 12-month average of GDP Growth.

    LEI-GDP-041813

    I am currently expecting an uptick in the Q1 2013 GDP report at the end of April.  The annual rate of change in the LEI index suggests this to be the case as well with the uptick going into the end of 2012.   However, I suspect that the Q1 GDP report will likely be the highlight of the first half of the year as the LEI is confirming the basket of economic indicators that I follow that suggests the Q2 will witness a fairly sharp slowdown.

    With earnings, and in particular top line revenue, showing continued deterioration over the last several quarters, as shown in the chart below, there will be a point where even the Fed’s ongoing Q.E. programs will be unable to stem a reversion.

    S&P500-OperatingEarnings-2009-041613

    With all fund managers now fully allocated to the financial markets, and all of them universally bullish, it is highly possible that investors could easily be swept up in a 10-20% correction sometime this summer.  The table below is from Zack’s Research which shows major investment firms expectations of the S&P 500 over the next 12, 36 and 60 months.

    zacks-return-outlook-041813

    Not one of them expects a negative return over the next 5 years.   Bob Farrell’s Rule #9 states: “When all investment professionals agree – something else is likely to happen.”

    While the index has corrected enough in recent days to provide a decent reflex bounce it is likely that such a bounce should be used to sell into.  We are quickly wrapping up the seasonally strong investing months of the year and the last four summers, in particular 2008, have not been kind to investors.

    The risks of slowing economic growth, a weakening consumer and deteriorating market fundamentals all suggest that investors should be a bit more defensive in their allocations.  The problem is that such a statement is always a function of timing.  If investors don’t see an immediate crash in the markets they assume the analysis is incorrect.  However, the reality is that turns in the economy, and the markets, are slow and can detach from logic for an extended period of time.  This is particularly the case when there are massive artificial influences at play.  However, the reversions, when they occur are fast and brutal and leave individuals with little time to react.

    As savers our job is to protect our principal.  Therefore, in order to do that we need to stop“gambling in the casino” and learn to be happy with “what is enough.”   After all its only the“house” that gets rich if you overstay your welcome at the poker table.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of Streettalk Live

    lance robertsAfter having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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