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Is this the summer swoon of 2010 revisited?
06/07/2011 8:30 am EST
Or at least that’s the fear.
Last summer the U.S. economy slowed with U.S. GDP growth dropping to 1.7% in the second quarter of 2010 from 3.7% in the first quarter of the year and from 5% on the fourth quarter of 2009. In 2011 GDP growth has dropped to 1.8% in the first quarter from 3.1% in the fourth quarter of 2010. And economic indicators are pointing to weak growth in the second quarter that closes on June 30.
And last summer the stock market went into a significant swoon. From an April 26, 2010 close at 1212, the Standard & Poor’s 500 stock index fell 15.2% to 1028 on July 6. Stocks then recovered to 1126 on the S&P 500 by August 5 before giving up almost all that regained ground and hitting 1047 on August 26.
From there the market staged a sustained rally, climbing 30.3% to 1364 on the S&P 500 on April 29 from that August 26 low.
You can understand feelings of déjà vu as we head into the summer of 2011. And the fear. The S&P 500 hit a high on April 29, almost the same date as the 2010 high on April 26. From there the S&P 500 has lost 4.9% and the index finished lower last week for a fifth straight week.
So how likely is it that the summer of 2011 will turn into a replay of the summer of 2010? That would mean we’re in for another 10% drop from here.
And what, if any changes in your portfolio, should you make?
The fear in 2010 was that that economy was slipping back toward a double-dip recession—or at best to a period of stagnant growth as the effects of the February 2009 stimulus package wore off and the Federal Reserve started to reduce its balance sheet. The Federal Reserve had started to buy mortgage-backed securities in November 2008 to help stabilize the financial markets in the wake of the Bear Stearns and Lehman Bros. bankruptcies. By June 2010 the Fed’s balance sheet had reached $2.1 trillion, up from $700 to $800 billion before the crisis and the bank had decided to halt further purchases because the economy had started to improve. That had the effect of gradually reducing the Fed’s holdings as debt securities matured. In June the Fed’s balance sheet was projected to fall to $1.7 billion by 2012.
In June 2011 the 2009 stimulus package is even further in the rear view mirror and in the first quarter higher oil prices cost the U.S. economy about $120 billion, enough to pretty much wipe out the stimulus from the December lame duck tax package. The Federal Reserve has announced that its second round of bond buying, QE2, will come to an end in June although the bank has not yet said when it will stop buying new Treasuries as current holdings mature.
The parallels get even stronger if you include the euro crisis.
By the end of April 2010 the Greek debt crisis had panicked European financial markets and politicians. Would Spain be next? Could the United Kingdom get sucked in? Germany’s leader Angela Merkel voiced the opinion that Greece should never have been allowed into the euro.
By May 2011 it was clear that the initial May 2010 bailout of Greece wasn’t going to work as planned. The country’s finances had continued to deteriorate with revenue falling well below projections and asset sales lagging. Greece was supposed to be able to start accessing the financial markets to sell debt in 2012, but the country was clearly going to remain locked out of the markets for longer than that. Halting Greek progress on increasing revenue and cutting spending led Jean-Claude Juncker, head of the Eurozone’s group of financial ministers, to question the ability of the International Monetary Fund to pay out its part of the $17 billion that Greece needed to fund its debt in June. Without those funds, Greece looked like it could be headed for default.
The parallels aren’t nearly so close when you compare how the financial markets and the U.S. economy worked their way out of the slump in June 2010 and the available options in June 2011.
Some of the comparisons are quite grim.
In 2010 the Federal Reserve could launch a new program of quantitative easing, saying, first, in August that it would start buying Treasuries and mortgage-backed securities to replace issues that had matured in order to keep the Fed’s holdings at current levels. Then, second, in November, the central bank announced a new buying program that would add $600 billion to the Fed’s balance sheet by the end of the second quarter of 2011.
In 2011 the Fed doesn’t appear to be seriously contemplating a third round of quantitative easing. Politically, it would expose the Fed to even more criticism at a time when critics of the bank’s policies have already turned up the heat. And economically, the Fed faces pressure from the interest rate increases by the European Central Bank to begin normalizing U.S. interest rates.
In 2010, while a new stimulus package seemed dead in the political waters, the economy got an unexpected stimulative boost from the Congressional lame Duck financial compromise.
In 2011 the best the economy can hope for is that Congressional negotiations over raising the debt ceiling and over the fiscal 2012 budget don’t produce cuts in short-term spending that make a weak economy even weaker.
In 2010 the leaders of the European Union managed to come up with a “solution” to the Greek debt crisis that promised to kick the problem down the road into 2012. The European Central Bank was still committed to keeping interest rates steady and monetary policy focused on economic growth.
In 2011 the leaders of the European Union look like they’ll craft a “solution” to the Greek debt crisis that promises to kick the problem down the road into 2013. The European Central Bank, however, has raised its benchmark interest rate once and has shifted its focus to fighting inflation.
In 2010 central banks in emerging markets had just begun a cycle of interest rate increases designed to combat inflation. Brazil, for example, raised rates for the first time in more than a year in April 2010. China followed suit, but not until October. At the time of the 2010 summer swoon, interest rate increases in emerging markets to fight inflation were certainly on the radar screen but the thought was that the cycle of rate increases would be relatively short—Brazil would be finished by the third quarter of 2011, economists then projected—and inflation would be contained with relatively little danger to global growth.
In 2011 inflation has proven to be much less easy to control and interest rate cycles much more extended than expected. Economists are now talking about the possibility of inflation in Brazil and China, for example, peaking in late 2011 or even in early 2012. One consequence of the Federal Reserve’s two programs of quantitative easing has been a global flood of cash that has pushed up exchange rates and exacerbated inflation in developing economies. All this has created fears that the extended cycle of interest rate increases will be extended enough to significantly slow economic growth in developing economies, and especially China.
In 2010 financials, a key leadership sector for stocks, were staging a recovery from the depressed prices of the financial crisis. For example, Citigroup (C), which had needed a government rescue, had rallied 38% from December 31, 2009 to its high on April 16. The stock fell along with the markets in the summer swoon but by the end of the year it was 4% higher than it had been in April and was up 44% for the year.
In 2011 investors have huge doubts about key leadership sectors. Financials don’t seem like bargains ready for a recovery; instead investors have focused on slow loan growth and the way that new banking regulations will eat into profit margins. Technology stocks, which are cheap on a historical basis, seem risky because investors see echoes of the dot.com bubble in the initial public offerings of LinkedIn (LNKD) and China’s Renren (RENN).
Not every comparison is grim, however.
Investors who have been through the economic slump of 2010 have a better appreciation for the start-and-stop nature of a recovery from a financial crisis. Economies may come booming back with 4% growth or higher after your run-of-the-mill recession but the recovery from a Great Recession, which rocked the global financial system to its core and left the financial landscape covered with the burnt out shells of financial assets, is much more halting. Global markets and global economies still have a huge backlog of problem assets to work through. The upshot is that I hear a lot less talk of a double-dip recession in 2011 than I did in 2010.
The European Central Bank has started to raise interest rates. We’re only one rate hike into the cycle but I think the bank is likely to raise rates again in July. Why is this important? Because a stronger euro, the result of higher euro interest rates, almost certainly means a weaker dollar and that would be good for the prices of commodities, commodity-related stocks, and the stocks of commodity-heavy emerging markets.
I think that a combination of interest rate increases from the European Central Bank and a new “solution” to the Greek crisis are likely to make the swoon in European and emerging markets stocks less extended than any U.S. drop—just as it was in 2010 when that “solution” to the Greek crisis turned those markets around by early June.
European (and Japanese) markets, as measured by the MSCI EAFE index (EFA), peaked earlier than the U.S. stock market—April 14 instead of April 26—and fell slightly harder, falling 19.8% instead of 15.2% for U.S. stocks from its April high to its summer low. But that low came significantly earlier, June 3 instead of July 6.
Emerging market stocks, as measured by the MSCI EEM index (EEM) show a similar of earlier recovery. Emerging markets peaked on April 6, fell 15.5% to their low on May 24, showed a second dip on June 30 (instead of August 26 for the S&P 500) and then rallied to their November peak.
So what should you do?
I think you can count on a slowing U.S. economy over the next quarter or two or more. If you’ve been following my longer-term view on the shift from out-performance in the U.S. stock market for the first half of the year shifting to under-performance in the second half of the year, you’ve already been lighting up on U.S. stocks. I’d continue that move, especially by reducing your holdings of U.S. financials. (I’ll have a move in that direction in my Jubak’s Picks http://jubakpicks.com/ later today.)
I’d be looking to put some of the cash you’ve generated from that lightening up to work in European and in emerging markets as soon as you see signs of a sustained upward trend in those markets. I think I can see that in European markets now, although I’d like a little more confirmation. And I have a suspicion that we’ll see encouraging signs from some emerging markets in the next week or two.
I’d certainly wait until the European Central Bank speaks on interest rates on June 9. They’ve disappointed investors before this spring by pulling back on the schedule for increasing rates. If they disappoint on June 9 for a July hike, I think European and emerging markets will drop. I’d certainly like to avoid that. I’ll give you a pick or two in the next few days so you can do your due diligence and be ready for the bank to speak.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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