Financial stocks were the first to crack in the Great Financial Crisis due to their sensitivity to credit and liquidity conditions. If they break down in Europe as well, you need to consider battening down the hatches. Four things you can do now, writes Mike Larson.
My brother is the doctor in our family, so he’s the one to consult on surgical issues rather than me. But you don’t need several years of medical school and residency to know some things. Like how treating the symptoms of a condition, rather than the condition itself, ultimately won’t work.
That’s what I got to thinking Tuesday as the Italian bond market imploded ... again. The year on the 2-year Italian Treasury note soared a stunning 170 basis points (1.7 percentage points) in just a few hours. They’ve now swung from negative-0.15% in mid-May to as high as 2.83% on Tuesday.
How crazy is a move like that? It’s like what would happen here in the U.S. if the Federal Reserve hiked interest rates seven times by 25 bps each ... in one day! So far in this rate-hiking cycle, the Fed has only raised them six times – and taken 29 months to do it.
What the heck is going on? Italy’s President Sergio Mattarella refused to accept the candidate for economy minister that a coalition of political parties offered up. He said the minister, Paolo Savona, was too much of an anti-euro guy, and that his nomination would cause turmoil in the European debt, stock, and currency markets.
But by defying the overall will of the Italian people, more than half of whom voted for populist political parties in March elections, Italy’s president is playing with fire. His move ensures the political chaos in Italy will drag on for weeks, if not months. And the ironic thing is his refusal brought about the very market turmoil he hoped to prevent. Specifically ...
- In addition to the surge in the 2-year yield, the 10-year yield jumped to 3.4%. That was the highest since 2014.
- The euro currency extended its rout, falling to as little as 1.1526 against the dollar from around 1.25 back in March.
- European stocks also fell broadly, with European banks hit particularly hard. The one I flagged recently, Deutsche Bank (DB), tanked again – trading to within a whisper of its all-time low from September 2016.
But what’s happening here is much, much more important than many investors realize. It’s about so much more than the level of Italian interest rates, or the price of German bank stocks. It’s about the point I made earlier: If you’re hacking like crazy because you have lung cancer, taking an over-the-counter cough suppressant might temporarily suppress that symptom. But it will do absolutely nothing for the underlying illness!
Think back to the first phase of the so-called “PIIGS” crisis in 2011-2012. The acronym stood for the names of the European countries at the heart of the crisis – Portugal, Ireland, Italy, Greece, and Spain.
European Central Bank President Mario Draghi pledged to do “whatever it takes” to “fix” it. The ECB began massively intervening in European markets, buying up trillions of euros worth of government bonds, and launching multiple programs designed to flood the economy with cheap, easy loans.
But the recent turmoil proves he didn’t fix anything. All he did was temporarily paper over the problem by artificially inflating European bond prices and artificially suppressing interest rates. Excessive debts weren’t written off. Reckless banks weren’t allowed to fail. Governments weren’t punished for enacting fiscally irresponsible policies. The underlying illness only grew worse.
Now, Italy owes about 2.26 trillion euros in government debt. The combination of that huge debt load and its stagnating economy has driven Italy’s debt-to-GDP ratio to a whopping 132% - second only to Greece in the eurozone! Furthermore, it will have to “roll over” more than 150 billion in debt each of the next three years as old bonds mature. That process will get prohibitively expensive if yields keep soaring.
What does this mean to you as an investor?
Well, plenty of tired, lazy, wet-behind-the-ears bulls will tell you that Europe’s struggles are exactly that – Europe’s struggles. Who cares!
But that sounds like pure claptrap to me because the list of countries experiencing financial turmoil is getting longer every day. Argentina. Turkey. Brazil. Malaysia. Indonesia. Each and every one is seeing their currencies falling, their stock markets reeling, and their debt markets coming under pressure. Now the sickness has spread to Europe.
But if THAT’s not enough to concern you, then remember the point I’ve made repeatedly in the last several months. This isn’t just an emerging market debt problem, or a European debt problem. Those problems are just symptoms of the broader underlying sickness: The Everything Bubble that has infected so many corners of our financial system and so many different asset classes.
As all the excess liquidity and easy money that caused this disease drains out again, we’re going to see volatility rise sharply, market sell offs spread and intensify, and things begin to come unglued at the seams. In fact, I’m closely watching the Financial Select Sector SPDR Fund (XLF) as a possible “canary in the coal mine” that we’re already transitioning into the next, more dangerous phase of this process. Look at this chart:
You can see that in the recent rally, the XLF failed to do anything more than test the underside of a broken trendline. After the holiday weekend, it gapped down below another trendline and the 50-day moving average – then cracked the 200-day MA.
Financial stocks were the first to crack in the Great Financial Crisis due to their incredible sensitivity to credit and liquidity conditions. If they break down here as well, you need to consider battening down the hatches – because it will be technical confirmation that all my cautious/negative fundamental worries are really getting the market’s attention.
What are the best practical moves you can make as an investor here?
- Reduce your overall stock market exposure, and leave the funds raised from that selling process in cash.
- Raise the “safety profile” of your remaining portfolio, by shifting more money into highly rated stocks that offer attractive dividend yields in defensive sectors. Think utilities, or even some beaten-down consumer staples that finally look to be finding some support.
- Get rid of Sell-rated stocks that our Weiss Ratings system suggests are more vulnerable in any market environment (and incredibly so in a bearish one). You can use the search tool right at the top of our website http://www.weissratings.com to check ratings on the names in your portfolio.
- Use inverse ETFs to hedge your downside risk or shoot for profits from falling markets and sectors. Financials are an obvious weak link. But I’d also keep an eye on wildly overvalued, overhyped, overloved tech stocks. They’ve been market leaders for a long time, but I believe they’re getting closer to a breaking point.
These moves won’t just ease the symptoms caused by a short-term market decline. They’ll help inoculate you against the underlying sickness that’s causing it – the massive, all-encompassing Everything Bubble.
Until next time,
Mike Larson
Check out Mike’s short video interview What Investors Are Doing Wrong and How to Fix It at MoneyShow Las Vegas here:
Duration: 2:22
Recorded: May 14, 2018.
Check out Mike’s short video interview at MoneyShow Orlando: How to Find Dividend Stocks here.
Duration: 2:26
Recorded: Feb. 9, 2018.
Follow Mike @RealMikeLarson on Twitter and subscribe to Weiss Ratings products here.
