"We Have All Been Here Before"
-Déjà vu, David Crosby, 1970
It's like we're living 2011 all over again in investment markets. And despite all of the lather about the strong stock market rally since the beginning of the year, if we learned anything from 2011 it was that even markets that are high on monetary stimulus could take sudden and unexpected turns.
The similarities between 2011 and what we've seen so far in 2012 is notable.
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In 2011, the stock market as measured by the S&P 500 (SPY) opened the trading year at 1257 and was riding high on a wave of monetary stimulus following the launch of the Fed's second round of quantitative easing the previous fall.
In 2012, stocks also opened the year at 1257 and have been riding high on a wave of monetary stimulus following the launch of the Fed's Operation Twist last fall coupled with the European Central Bank's (ECB) Long Term Refinancing Operations (LTRO) starting last December.
In 2011, the stock market gained +6.8% to a peak on February 18 at 1343 on the S&P 500. Bullish investor sentiment reached a peak of 51.5% during the month according to the American Association of Individual Investors (AAII).
In 2012, the stock market has gained +6.8% year to date to close on February 15 at 1343 on the S&P 500. Bullish investor sentiment recently peaked at 51.6% during the month according to the latest data from the AAII.
In 2011, the stock market began to buckle in late February due to a variety of pressures. These included uncertainty associated with social unrest in Libya and Egypt, the fallout effects from the earthquake and tsunami in Japan, a looming standoff on raising the debt ceiling in the U.S. Congress and a European crisis that was quietly smoldering under the surface. Stocks subsequently sold off and entered into a violent sideways trading channel through July.
First, the stock market corrected by -6.4% through March 16. It then bottomed and rallied by +8.5% through April 29 followed by a -7.2% correction through June 15 and a last gasp +6.9% rally through July 7. Just one month later by August 8, the stock market had cascaded lower by -17.3% and it looked like all hell was going to break loose. Only for some assertive policy acrobatics by global central bankers in the second half of the year was the market able to eventually claw its way back to where it started the year by the end of 2011.
In 2012, the fate of the stock market is still to be determined. But a few facts are readily apparent as we move into the great unknown that is the remainder of the year. First, the potential challenges facing the stock market are far more dramatic than they were a year ago. The situation in the Middle East is not vastly more complex. Not only is the situation in Egypt and Libya still highly unstable, but Syria is now also experiencing potential transition, Iran is waving around a potential nuclear threat and Israel is reportedly preparing to respond with force.
While Japan continues to recover from the tragic natural disaster from a year ago, we are now seeing signs of slowing economic activity both in Japan and China. As we all know, the fiscal situation in the U.S. is still far from resolved with a budget deficit that continues to expand with no clear resolution in sight. But lastly and perhaps most importantly, the crisis in Europe is now fully ablaze with Greece teetering on the brink of actually carrying out a long overdue default and several other peripheral sovereigns including Portugal, Ireland, Spain and Italy now in the crosshairs. If the risk for a financial accident was a concern in early 2011, it is profoundly more so at present in 2012.
"If I had ever been here before I would pro'bly know just what to do.
Hey, don't you?"
-Déjà vu, David Crosby, 1970
It has been striking how complacent many investors have been in the current environment. A 100% allocation to equities? Really? I have a great deal of respect for Mr. Fink and am always interested to hear his perspectives. But even suggesting that investors make a full allocation to any single asset class in the current environment, particularly one like stocks that has behaved so unpredictably over the last several years, is not only imprudent but in fact arguably a bit reckless. This is only one of many examples of the bullish overconfidence that one would expect to see at or near a stock market top.
So what can we reasonably anticipate from here for the stock market? Three outcomes appear most likely.
The first would be a short-term pullback. The market is overbought and is now overdue to retrace and consolidate some of its recent gains. And this outcome would be consistent with what we saw in 2011 where the market corrected by -6.4% from mid February to mid March. But here is the problem. In today's market that is now seemingly filled with David Tepper imposters, a very strong consensus is building behind this short-term pullback buy the dip view. But as we all know too well, when consensus is established behind any particular view, it usually ensures that it won't actually happen in the end.
A second possibility would be a more prolonged decline. I would actually assign a solid probability to this outcome at present. Many investors are counting on the Tepperesque notion that as stocks retreat that additional policy largesse will quickly revitalize the market (notice that Mr. Tepper himself is nowhere to be found expressing this view today).
But the problems facing the global economy today may now be starting to expand beyond the scope of policy makers to fully contain. Moreover, the risk of a policy accident is rising as global central banks become more and more aggressive with their actions. This sets up for the potential for markets to fall longer and further on any pullbacks than most may be anticipating.
"Do you know? Do you wonder? What's going on down under you"
-Déjà vu, David Crosby, 1970
And, of course, the third possibility is that the market continues to rise to the sky. This also merits a reasonably probable outcome. The power of monetary policy stimulus on the stock market should never be underestimated. Such forces can cause stocks to rise beyond all rationale (I would argue they already have to this point). And as long as the much needed cleansing process is postponed into the future, markets have the potential to become all the more intoxicated by the ongoing stream of endless money printing. Of course, such stimulus will eventually need to be withdrawn, but that potentially is an incredibly painful unwind that would be left to worry about another day under such a scenario.
So what is the best strategy given this backdrop and widely divergent potential outcomes? Stay nimble and stay hedged. It is still worthwhile to hold stock allocations in the event that equities continue to rise, regardless of whether this advance makes sense or not. In order to control the risk associated with this allocation, focusing on the more defensive areas of the market such as food companies and utilities remains worthwhile.
Representative names include WGL Holdings (WGL), which is approaching a potentially very attractive entry point at its 200-day moving average. Others include McDonald's (MCD) and JM Smuckers (SJM), both of which are currently trading at support on their upward sloping 50-day moving averages. And the trade in Kellogg (K) on Wednesday highlights the appeal of allocating to defensive names that had been recently sold off.
Even better opportunities exist outside of the stock market. Precious metals including gold (GLD) and silver (SLV) remain near the middle of their recent trading range and offer the dual appeal of hard asset protection against further global central bank money printing as well as safe haven protection against crisis. More stable categories such as U.S. TIPS (TIP) and Agency MBS (MBB) are also strong choices in the current environment for their steady price performance and safe haven characteristics. And for those seeking to directly protect against a stock market decline, establishing a position in Long-Term U.S. Treasuries (TLT) may also be worth consideration.
It will be interesting to see as we move through the rest of February whether our market state of déjà vu continues or if 2012 finally begins to forge its own path. In the meantime, keep a close eye and stand ready to act accordingly if necessary.
Disclosure: I am long GLD, SLV, TLT, MCD, SJM, WGL, K, TIP, MBB.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
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