Risk Can Happen Fast In Our Interconnected World
All of life is an exercise of taking risk, which is also the essence of investing.
That said, we as investors and traders must always consider risk vs. reward by asking ourselves a fundamental question: "What's the upside and downside to each and every one of my decisions?"
When I ponder that question these days, I find that I remain fearful of the markets and see an unfavorable risk-vs.-reward quotient.
I recently referred to the Brexit as "The Big Chill" (click here and here), concluding that a number of headwinds would grow out of it -- especially contagion risk. I believe that these headwinds will underscore the global economic recovery's fragility, along with central bankers' impotence and the deleterious impact on negative interest rates. Add it all up and I expect a less-favorable and potentially unfriendly valuation backdrop.
Let's look at why:
The World Is Flat and Interconnected
Since Wall Street hit its "Generation Low" in March 2009, investors have literally scoffed at untoward events -- whether political, economic, terrorism-oriented or anything else.
But I believe that while the bulls see the Brexit vote as a non-event, they're likely wrong. Instead, I expect that we're already beginning to feel the effects of a slow reversal in the globalization that's long been prominent in our flat and interconnected world.
The dominoes have already begun to fall. For instance:
The British Pound Is Collapsing. "Cable" is under 130 this morning, which could exacerbate global deflation.
U.K. Property Values Will Likely Drop. Buoyed by high-paying finance jobs that might now be exported, U.K. property values will probably be in retreat. (Click here to see my colleague Antonia Oprita's analysis of that.) But unlike what happens in America, real-estate collateral is at the heart of many large and small British companies' trade and project finance.
Liquidity Pressures Are Rising. As Oprita noted in her column, several U.K. property funds have imposed trading gates on redemptions. That's eerily reminiscent of 2007, when several mortgage funds halted redemptions. They ultimately failed anyway, heralding in the Great Recession.
The EU Banking Crisis Takes Center Stage. I believe that the European banking crisis (which I highlighted in Is Deutsche Bank The Canary in the Coal Mine?) will now be in full bloom. For instance, markets ignored the Italian banking crisis for months, but it's likely to take center stage now. The problem will also probably spread to other peripheral European Union countries' banks, which are generally mismanaged, leveraged and befuddled by massive amounts of nonperforming loans. This could ultimately destabilize European politics and spark a trend of more economic populism and less globalization.
America Will Not Be an 'Oasis of Prosperity.' No country is an island in today's interconnected world. We won't be unaffected by the chaos that I expect to occur outside of our borders.
As I've previously discussed, 2016's major economic themes prior to the Brexit vote included an economic ebbing, increased concerns that zero and negative interest rates were destructive and a growing fear that central-bank intervention was becoming impotent.
But now, all of these trends seem destined to worsen in the Brexit referendum's aftermath. The ensuing flight to safety might lead to lower global interest rates, but might not inflate price-to-earnings multiples (as bulls like my pals Tom Lee and Tony Dwyer are arguing).
Indeed, zero and negative rates could have the opposite effect by further retarding a capital-spending recovery while leading to less consumption and more cash hoarding by the savings class. (This is the so-called "Paradox of Thrift.")
The above explains how I expect the Brexit vote to have far worse long-term effects than the market's bulls seem to realize.
Let's take a look at what I think will happen:
Growing Recession Risks
I plan to revisit my S&P 500 fair-market-value estimate later this week.
My prediction is currently at around 1,900 vs. the S&P 500's 2,088.55 close yesterday, but I expect to reconsider the underlying assumptions that this estimate incorporates (earnings projections, interest rates, inflation, valuations, etc.).
I also plan to update the five broad economic scenarios that play into my forecast. Remember, I last saw a 35% chance of a "garden-variety" recession in 2016-17, as well as a 15% chance of a deeper recession.
By contrast, Deutsche Bank recently predicted a 60% chance that a recession will occur in the next 12 months, based on the yield curve's shape. (I included DB's comments inyesterday's opening missive.)
The Near Term
I generally agree with Jim "El Capitan" Cramer's assertion that there's always a bull market somewhere -- but I see an unfavorable, limited upside to U.S. stocks these days relative to a potentially deep downside. After all, we have a deteriorating global economic backdrop, elevated price-to-earnings ratios (23x GAAP for the S&P 500) and what I see as a quiet, rotational bear market.
"Safe havens" like utilities, staples and fixed income are seeing strength, with a continued"Great Rotation" of investors moving into those sectors. We're also seeing a continued climb in precious metals. All of that speaks to a U.S. slowdown and/or recession.
These trends have created the appearance of a better market on the surface (i.e., in the S&P 500). But I believe that stocks are suffering under the surface. It looks like transports, autos, housing, retail, banking and other sectors are all breaking down and rolling over.
The Intermediate Term
To me, the market's gyrations since the S&P 500 hit its May 2015 high all point to the ongoing formation of a large, important market top. But as we've learned frequently from the market swings that we've seen since then, false technical signals and damaged chart patterns are the prevailing conditions in our market these days.
That's not surprising given that Wall Street is heavily populated by quants and operates without memory from day to day. But what I'm most fearful of this morning is a market that's providing a wholly unfavorable risk-vs.-reward quotient.
Buyers live higher and sellers live lower in our brave, new world -- but it's an unpredictable one that's filled with uncertain economic and market outcomes. It's also dominated by volatility-trending and risk-parity strategies and the like that allocate capital based on the market's volatility and price action.
So, consider yourself forewarned. These days, risk can happen fast in our interdependent, interconnected world.