3 scenarios that could turn minor bad news into major damage to your portfolio

03/27/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Last week the Standard & Poor’s 500 Index suffered its biggest drop since December. The index’s 0.5% decline for the week wasn’t huge, but it stands out in the context of a market that has been up in 10 of 11 weeks in 2012. The Dow Jones Industrial Average fell more on the week, 1.2%, after reaching its highest level since December 2007 on March 15. The Dow Jones Transportation Index, which reacts strongly to sentiment on the U.S. economy, lost 2.5%. That’s the biggest drop in that index since November 25.

I don’t want to make too much of a one-week decline. You get them in every rally and a 0.5% or 1.2% pullback isn’t much considering how far we’ve come in 2012. Even after the drop last week, as of March 23, the Standard & Poor’s 500 Index was up 11.09% for 2012.

And certainly the news behind the drop was terribly familiar. Economic indexes in China and Europe showed evidence growth there was slowing. Oil prices stayed elevated at just north of $125 a barrel for benchmark Brent crude. Yields on Spanish debt climbed. Nothing here really new.

But I don’t think we should automatically dismiss this as a routine decline on familiar news. And that’s because like many other dynamic systems, the financial markets aren’t totally linear. At some point the markets can turn steady and not terribly large moves into a much bigger change. And it’s those nonlinearities of the market that worry me—and I think many investors—most right now.

I can see three different scenarios that might hit a point where a series of small incremental changes turns into a much bigger move. One that is different in kind. And not just business as usual for a rally with its typical corrections. I’m not saying that any of these scenarios are guaranteed to occur but they all loom as possibilities on the not too distant horizon and you ought to figure that risk into your strategy for investing right now.

For example, take the rising price of oil, my first nonlinear scenario.

The consensus among Wall Street economists is that while rising oil prices will cut into economic growth, the damage to growth will be modest--as long as the increase in the price of oil is gradual and the overall increase isn’t too dramatic. For example, Goldman Sachs projects that a 10% increase in the price of oil would cut 0.25 to 0.5 percentage points off U.S. economic growth. With growth for 2012 forecast at 2% to 2.5%, a decline in growth of that dimension—which would take U.S. growth to anywhere from 1.5% to 2.25%--wouldn’t help the economy or the stock market, but it wouldn’t be a disaster either.

But scale up the rise in the price of oil to the kind of jump we might see from an attempt by Iran to close the Straits of Hormuz to oil traffic and the disruption jumps in seriousness. A disruption to oil flowing through the straits would, according to IHS Global Insight, take 1.5 percentage points off economic growth in the EuroZone, the part of the global economy most dependent on imported oil. That would be enough to turn what is already predicted as a mild recession in the first half of 2012 into a deep recession in the EuroZone. And that could be enough to send Spain and Italy into crisis.

That is, you should have guessed, my second nonlinear scenario.

I think Spain is the likely locus of any new crisis. Right now we’re witnessing a slow but steady increase in the yield on Spanish 10-year bonds. Yields climbed by 0.19 percentage points last week to close on Friday, March 23, at 5.37%. That’s still a long way from the yields north of 7% that Spain saw in the worst of the last round of the Greek crisis. But yields are definitely headed in the wrong direction right now.

At the beginning of March Spain told the EuroZone countries that it would miss its budget deficit target of 4.4% for 2012 by a huge margin. The deficit, said Prime Minister Mariano Rajoy would be 5.8% of GDP. That took European leaders aback, especially when Rajoy presented resetting the deficit target as a “sovereign decision” by Spain. After a little horse-trading, everyone agreed on a budget target of 5.3% in the budget to be announced by Spain on March 30.

For 2013 Spain remains committed to reducing the deficit to 3% of GDP.

That’s going to be difficult if the Spanish economy continues to shrink at something like the 0.3% contraction in the fourth quarter of 2011. The International Monetary Fund forecasts that it will, projecting that the Spanish economy will contract by 1.7%.

But it’s going to be just about impossible if oil prices spike and cut another 1.5 percentage points off growth. Remember this is a country already facing 23% unemployment.

A Spanish debt crisis wouldn’t be like a Greek debt crisis. Spain’s current government debt is a relatively low 66% of GDP. But private debt stands at a huge 220% of GDP. An austerity program that slowed the Spanish economy even further and made it harder from the Spanish private sector to carry its debt would push the country toward some kind of public assumption of private debt. (A version of Ireland’s bank bailout, perhaps? That’s a cheery thought.) That’s already happened to a degree as the Spanish government has stepped in with public money to support the merger, acquisition, or liquidation of the weakest of its caja banks. But if the economy continues to shrink, I think that process will accelerate. That, of course, would push the Spanish government deeper into a hole just as EuroZone countries are signing up for an agreement on fiscal discipline that would set even tighter limits on budget deficits.

Spain worries EuroZone leaders enough so that they’re looking for a way to increase the current 500 billion euro-limit on the European Stability Mechanism, the permanent bailout fund set to go into operation this year. That fund will replace the current European Financial Stability Facility. But while unused funds from the facility would move over to the mechanism, the permanent fund would still only have a 500-billion limit under current rules. (Got that?) When finance ministers meet starting on March 30, they’re expected to look for a way to have the two funds operate in tandem so that the unused funds from the Financial Stability Facility can add to the 500-billion euro limit. That would bring the total bailout funds available to 692 billion euros. That might be enough to convince the markets that Spain is not in jeopardy. In that case the fund would never actually need to be used. That’s the hope anyway. Since if Spain needs a bailout, then Italy moves to the front line, and even the bolstered facility isn’t enough to cover both contingencies.

My third non-linear scenario is set half way across the globe in China.

On March 22 the Agricultural Bank of China, China’s largest rural lender by assets, announced a 29% increase in profits for 2011.

Taking a bit off the shine on that good news was the bank’s report that it would set aside about $9.3 billion to cover a potential increase in bad loans. That was a 48% increase from what the bank set aside to cover potential bad loans in 2010. Investors were entitled to a certain confusion at the announcement since at the same time as the bank increased its provision for potential bad loans, it announced that its non-performing loan ratio had actually declined to 1.55% in 2011 from 2.03% in 2010.

That’s because investors had missed the memo. Last month the China Banking Regulatory Commission told lenders that they had misclassified about 20% of their outstanding loans to local governments. The banks had placed these loans in their safest category declaring that the loans were fully covered by cash flows from the local government projects. That wasn’t exactly the case for what amounted to 1.8 trillion yuan ($286 billion) in loans. When and if banks reclassify the loans, they will have to set aside more money for potential loan losses (as Agricultural Bank of China did) and ask local governments for more collateral. Moody’s Investors Service estimates that 20% to 33% of these loans will go sour unless government at some level steps in.

If you’ve been wondering why everybody is so afraid of a hard landing in China, you’re now looking at the answer. If China’s economy slows to 7% instead of the 7.5% growth target set by Beijing for 2012, it won’t be a big deal in terms of jobs or company profits (especially company profits at state-owned enterprises.) But it will be a big deal for all these local government loans—whether direct or through the 6,000 some government affiliated financial companies or to local companies. Local governments don’t have a steady stream of tax revenue anywhere near big enough to cover the payments on these loans if projects go bad and if the local real estate market stops generating substantial revenue from land sales. A hard landing for China’s economy wouldn’t just cause an incremental increase in pain for local governments, affiliated financial companies, and the banks that lend them money—it could well be enough to create a need for Beijing to bail out China’s biggest banks and bury their bad loans again.

Okay, those are my three candidates for really bad things that could happen if oil prices rise higher and faster than expected, if European economies slip into a deep recession and the Chinese economy slows.

The question is, as always, what do you DO about those possibilities?

You, of course, watch to see how they develop. Investors will be able to track the direction and speed of oil prices without too much difficulty. The European Central Bank, the International Monetary Fund, and the Organization for Economic Cooperation and Development all publish forecasts on European economies. Data—well, trustworthy data, anyway--on China’s economy and banking system is harder to come by but the Chinese government, China’s banks, and the big credit-rating companies such as Moody’s and Fitch Ratings do provide a decent window into the health of the Chinese economy.

I think there’s also a strong argument for waiting on the sidelines while you watch. We’ll know a lot more about oil supplies (and disruptions) from Iran, Syria, Libya, and the Sudan in a few months than we know now. By June or so we’ll have a better read on whether the EuroZone is about to relive the Greek debt crisis again or not and on whether efforts to steady the Spanish and Italian economies are bearing any fruit. In roughly that same time period we’ll have a much better sense of how strongly the Chinese government, including the People’s Bank of China, intends to move to buttress growth and the banking system.

There is, in other words, a strong argument for moving some portion of your portfolio to the sidelines for a few months.

Your decision to do that or not ultimately will depend on your read on how likely any of my three scenarios are to come about. They aren’t exactly the kind of low frequency event (no black swans here) that it’s safe to ignore totally until it bites you—in my opinion—because they’re actually more likely than say the U.S. mortgage crisis or the collapse of Lehman. Although much less devastating to the financial markets too in my opinion. I’m not looking for a replay of 2008. But I wouldn’t be surprised to see a replay of some of the worst downside volatility of 2011—if any of these scenarios come about.

The danger of moving to the sidelines is, of course that you’ll miss any further move up in the markets—especially the U.S. stock market—if none of these scenarios come about and if, instead the U.S. economy is stronger than expected in the first half of 2012.

The way to make the most money in the stock market is, as always, to take big directional bets—and get them right. That’s also a reliable formula for how to lose the most money. (With the one change being that you get the directional bet wrong.)

Right now I don’t see the odds favoring big risky bets that this market will dodge all these scenarios—as well as the incremental negatives such as rising oil prices, and slowing growth in Europe and in China that could wind up not rising to the level that would produce a non-linear really, really bad outcome but that could still push down stock prices.

I’m going to play it cautious here. I’ll look for stocks with dividends, growth stocks selling at a reasonable price, and value stocks selling at really good prices and that are headed for a turnaround.

I think the best advice is to try not to force anything. If the market gives you a genuine opportunity, take it. But realize that the odds are that you’ll see an expanding number of opportunities over the next few months.

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 http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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