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Time to Lighten Up on US Stocks
06/07/2011 9:00 am EST
There are numerous parallels with the market's current malaise and last summer's 15% drop. And this summer's swoon could be even worse.
It's déjà vu all over again.
Or at least that's the fear.
Last summer, the US economy slowed. GDP growth dropped to 1.7% in the second quarter of 2010, from 3.7% in the first quarter and 5% in 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. Economic indicators are pointing to weak growth in the quarter that ends June 30.
And last summer, the stock market went into a significant swoon. From an April 26, 2010 close at 1,212, the S&P 500 index fell 15.2% by July 6, to 1,028. The index then recovered to 1,126 on August 5, before giving up almost all that regained ground and hitting 1,047 on August 26.
From there, the market staged a sustained rally, as the S&P climbed 30.3% from that August low, to 1,364 on April 29, 2011.
You can understand the 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 this summer will turn into a replay of the summer of 2010? That would mean we're in for a 10% drop from here.
And what, if any, changes should you make in your portfolio?
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 Brothers bankruptcies.
By June 2010, the Fed's balance sheet had reached $2.1 trillion, up from $700 to $800 billion before the crisis. The bank 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 trillion by 2012.
In June 2011, the 2009 stimulus package is even further in the rear-view mirror, and first-quarter higher oil prices cost the US 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. But the bank has not yet said when it will stop buying new Treasuries as current holdings mature.
These parallels are 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 last year's bailout of Greece wasn't going to work as planned. The country's finances had continued to deteriorate, with revenue 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 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 if you compare how the financial markets and the US economy worked their way out of the slump in June 2010 and the available options in June 2011.
NEXT: Some Comparisons Are Quite Grim|pagebreak|
Some Comparisons Are Quite Grim
In 2010, the Federal Reserve launched a new program of quantitative easing, saying in August 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, in November, the central bank announced a 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 more criticism at a time when critics of the bank's policies have already turned up the heat. And economically, the Fed faces pressure to begin normalizing US interest rates from the European Central Bank, which has begun to hike its rates.
In 2010, while a new stimulus package seemed dead in the political waters, the economy got an unexpected stimulative boost when payroll taxes were cut in the Congressional lame duck budget 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 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 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. Inflation would be contained with relatively little danger to global growth, experts believed.
- In 2011, inflation has proved to be much harder to control and interest-rate cycles much more extended than expected. Economists are now talking about the possibility of inflation in Brazil and China peaking in late 2011 or 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—especially China's.
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, 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 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 this time around. Investors are worried about 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).
NEXT: Not Every Comparison Is Grim, However|pagebreak|
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 will 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 hikes from the European Central Bank and a new "solution" to the Greek crisis are likely to make the swoon in European and emerging-market stocks less extended than any US 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 US stock market—April 14, instead of April 26—and fell slightly harder, falling 19.8% instead of 15.2% for US stocks from its April high to its summer low. But that low also came significantly earlier—June 3, instead of July 6.
Emerging-market stocks, as measured by the MSCI EEM index (EEM) show a similar pattern 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 US economy, at least over the next quarter or two.
If you've been following my longer-term view—specifically, outperformance in US stocks for the first half of the year shifting to underperformance in the second half, you've already been lightening up on US stocks. I'd continue that move, especially by reducing holdings of US financials. (I'll have a move in that direction in Jubak's Picks shortly.)
I'd look to put some of the freed-up cash in European and emerging markets as soon as there are signs of sustained upward trends there. I think I can see that in European markets now, although I'd like more confirmation. And I suspect 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. It disappointed investors earlier this spring by pulling back on the schedule for increasing rates. If it disappoints on expectations for a July hike, I think European and emerging markets will drop.
I'd 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.
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