Investing – Wait and See

Here are the highlights of this month’s investing article:

  • In May 2010, the European debt crisis, the feared slowdown in China, regulation in Washington and the Flash Crash drove markets down swiftly and harshly.
  • Going forward, much depends on whether the Debt Crisis in Europe can be contained, and whether China can prevent a burst of its own bubble. The US is hostage to events in Europe and China.
  • The technicals are decidedly bearish, with a break below 1040 on the S&P spelling trouble for the markets going forward, and a break above the 1110-1120 level could be bullish.

In the meantime, we are in wait-and-see mode. I’ve taken my clients to 40-60% cash, and plan on keeping exposure to the market low until a clear trend is established.

One quick note before proceeding. I’ve revamped the investing section of my website and relocated the blog there. So if you feel like exploring more, go to http://www.minglo.com/investing. This article is also posted in the blog in four sections.

Investing in the Month of May

So much has happened in the markets in the month of May that it’s hard to know where to begin. At the beginning of the month, I called for a correction. And we got one, albeit more severe than I expected. The catalyzing event was S&P’s downgrade of Greece to BB+, or junk, on April 27. Soon after, on May 6, we got the flash crash, when at one point during the day S&P was down as much as 100 points and the Dow had fallen almost 1,000 points. We recovered a bit as Europe rushed to put together a bailout package, but it was not long before we resumed the downward collapse. By the time it was all over, the markets had fallen as much as 12% from the April high. Stock market commentators tried to make sense of things, but the range of opinion is so wide it’s hard to know who to listen to. In one camp, the bulls were saying that a 10-15% correction, after the huge run in 2009, was to be expected. Some even put the correction in the 15-20% range. On the other hand, the bears were saying, it’s only going to get worse. As May closed, the press delighted in pointing out that May 2010 was the worst May since 1940, when Franklin Roosevelt was in office. The chart below (right click to enlarge) gives an overview of the month.

Key necklace

To get a handle on what happened in May, let’s break things down a bit. At the beginning of the month, there were four major catalysts that hit the market, all at the same time:

  • The European Debt Crisis. While the immediate catalyzing event was S&P’s downgrade of Greece, many saw it as a harbinger of more credit crises to come in the other four “PIIGS” (Portugal, Italy, Ireland, Greece and Spain). First, there was the liquidity issue, Greece’s need to fund debt that was rolling over. The $1 trillion aid package approved on May 10 by the European finance ministers could eventually mitigate this problem, but the market fretted that a “yea” by finance ministers was not the same as approval by many parliaments. In other words, the market wouldn’t feel better about things until checks were signed and cash was in the bank. Greece also symbolized a second issue, a solvency problem in the PIIGS. The fear was that Greece’s debt load was so high that even with austerity measures being put in place (and with violent objections from the populace, as everyone saw on television), Greece would eventually default on this debt. This means banks holding Greek debt would take losses. And because no one really knows how much debt many banks hold, other banks don’t want to lend to any bank that might have Greek exposure. Result: a mini-freeze in lending, both in Europe and internally. To be certain, Greece in itself wasn’t a big issue, but multiply Greece by the same situation in the other PIIGS and now we have a major problem.
  • Slowdown in China. Last year you would have had a hard time convincing people that China was in a bubble. Now it’s all but common wisdom. You can thank China itself for that – early this year, China has taken steps to slow down lending, including raising reserve requirements and increasing lending restrictions. China’s defacto acknowledgement of its real estate bubble has put a major crimp in commodities and international industrial stocks. Also, a year ago, the idea of China “decoupling” from the rest of the world economy was also all the rage. Nowadays, investors fear that a slowdown in Europe will also stunt China’s growth, because Europe is one of China’s largest trading partners, home to 20% of China’s exports. The fall in the value of the Euro makes Chinese imports more expensive, and the reluctance of banks to lend shuts down the letters of credit used in trade finance.
  • Regulation in Washington. It seems Washington is in the mood not just to reform, but also to punish. The assault on Goldman Sachs not only paved the way for financial reform, but also for a series of additions to the Senate reform bill that turned out to be much harsher than expected. The Senate passed its version of financial reform on May 21, near the recent low in the market. The House had passed its own version in late 2009, and the Senate and House versions have to be reconciled before financial reform can be passed on to the White House for approval. Worries about financial reform continue to hang over the markets.
  • The Flash Crash. In the midst of all these worries, we were struck by the “Flash Crash”. We still don’t know for certain what caused it, but the current theory is that markets were moving so violently that the NYSE shut down trading in several stocks so that a human opinion could intercede. At the same time, several computer trading programs shut down to protect themselves from the volatility. Meanwhile, other trading exchanges continued to trade, but with major sources of buyers absent from the market, the price of certain stocks dove off a cliff. Afterwards, there was much debate among technicians about whether this crash was “real” – i.e., whether they should incorporate the day’s volatility into their interpretation of trends and trading levels. The consensus now is that the Flash Crash was “real” and should be included in technical calculations. That means the market had a very high likelihood of trading down again to the lows established during the Flash Crash. In a matter of weeks, at the end of May, the market did exactly that.

I would also be remiss if I didn’t mention the Deepwater Horizon disaster in the Gulf. This is indeed a terrible event, one that will affect the environment, the economy and the livelihood of many for years to come, not to mention the lives lost. For the market, this was a surprise as opposed to an underlying trend. Still, the fallout, including the government reaction of suspending offshore drilling for six months, will hit the energy sector, commodities, job growth and will likely cause an increase in oil prices later in the year. Over the weekend, as the Top Kill effort failed, it became evident that the hole would not be plugged until later this summer.

Indeed, this is a lot to worry about for all of us.

The Outlook

Given all these issues, what’s the outlook going forward?

The Bull Case. There are many who remain bullish. Take for example these comments, excerpted from Goldman Sach’s US Weekly Kickstart report, published May 21, 2010:

“Developments over the past two weeks have not altered our fundamental view. The market has plunged 12% in four weeks, but remains 60% higher than in March 2009. The pull-back has been consistent with sell-offs that occurred in recoveries following bottoms in in 1974, 1982, 1987, 1990 and 2002. The correction has been orderly in that sector returns have been exactly in-line with beta-adjusted performance…

We expect the S&P to rise to 1300 by mid year (+21%), before ending 2010 at 1250 (+17%)…

We recognize the dramatic decline in the Euro, and the potential impact it may have on reported US corporate earnings if it persists through year-end. We acknowledge the risk that European economic growth may be weaker than many currently expect as a result of pending fiscal tightening. However, we remind equity investors that US companies in the S&P have total annual revenues of $8.4 trillion and Europe, Middle East and Africa combined explicitly account for just 10% of the total (and if charitably inclined, perhaps as much as 15% of the total if a generous allocation of sales to ‘Other’ regions is allocated to Europe).”

So you see the bull point of view: this is a normal correction within a bull trend, and the US has limited exposure to Europe. Other bulls cite continued low interest rates and favorable economic trends in the US. Furthermore, European troubles will lead to capital flowing into the US, while China is likely to continue stimulus in light of European troubles. That’s the bull argument, in a nutshell.

The Bear Case I – Liqudity and Solvency Issues. The bear perspective zeroes in on the headwinds pushing against a wobbly economic recovery. Following the 2008 Credit Crisis, all governments – including Europe, the United States and China – chose stimulus and bailouts to prevent further damage to economies. Problem is, stimulus has it price, and the bears say its time to pay. Having spent so much to prevent a collapse of the system, the European countries, and especially the PIIGS (Portugal, Italy, Ireland, Greece and Spain) have very high levels of debt. So the first problem is debt rollover – financing new debt when old debt becomes due. This is the liquidity problem. Because these countries have much high levels of debt than when they initially borrowed money, investors are demanding much higher interest rates on new debt. This is exactly what happened to Greece during the last several months. The $1 trillion European bailout package approved in May is meant to ameliorate that problem, but parliaments have to approve and checks have to be written.

In the longer term, many believe that the PIIGS have so much debt that they won’t be able to pay it back, no matter how much they clamp down on spending. So eventually, the banks that hold European debt will eventually have to accept losses on the sovereign debt (that is, debt of countries) that they hold. Greece in itself is manageable, but mutiply the problem by Spain, Portugal, Italy and Ireland, and you’ve got a problem of significant proportions. This is the solvency problem. Most expect that eventually, there will be debt restructuring, the equivalent of default.

Meanwhile, the European countries are facing a series of debt downgrades. Greece was downgraded to junk status at the beginning of May, and this precipitated the latest stock market decline. Spain was downgraded this last Friday, May 28, pushing to US market down 122 Dow points. This week France admitted that it would probably have a hard time holding on to its credit rating. So you can see, the bears have a point: no matter what good news appears, we’re going to be facing a series of credit downgrades. Plus, there’s lots of political risk: parliaments may not approve all the necessary measures, citizens may not cooperate (as the Greeks rioting in the streets shows) and the Europeans Union still has to find the political will to act.

The Bear Case II – A Slowdown in Lending. There’s also a second aspect to the bear case, and that is the a possible freeze in lending. In theory, debt restructuring is unlikely to occur for a long time. Still, banks don’t want to be exposed to other banks that might be facing major losses. So banks don’t want to lend to each other, and that could lead to a freeze in lending. That in turn, could seriously damage a nascent recovery.

Analysts monitoring the health of the banking system look at an indicator called the LIBOR-OIS spread. LIBOR is the London Interbank Offer Rate, and represents the rate banks charge each other to borrow in London. It also serves as the basis for many credit cards and commercial agreements. OIS is the Overnight Indexed Swap rate, the equivalent of the federal funds rate here in the United States. The difference, or the spread, reflects the risk in the system. When the spread is high, bankers see a risk in lending to each other. Take a look at the LIBOR-OIS spread for the last six months, and you’ll see a significant uptick in the month of May:

To be fair, we’re no where near the levels we saw in 2008. Take a look at a longer-term chart of the LIBOR-OIS spread, and you’ll see that it’s currently elevated, but far below the crisis levels in 2008:

Europe, the United States and China. There is more to these arguments – we have not yet discussed United States and China. Still, if you review these arguments, you can see that the key difference between the bull and the bear case is whether European problems can be contained. In the bull case, yes; in the bear case, no. If European problems can be contained, then the US is likely to have the time needed to solve its own problems, which include increased taxes, greater costs from regulation, states and municipalities in crisis, more real estate foreclosures and now a disaster in the Gulf of Mexico. If the European problems cannot be contained, it will only hamper efforts to solve the not insignificant problems at home.

China also is an unknown factor in the world economic system. By now, most accept that China is in, at the very least, a real estate bubble and that the Chinese economy is in danger of overheating. China basically admitted as much by taking steps, including clamping down on on lending, to rein in the system. China also is not immune to international problems. Many thought that China had “decoupled” – that is, become independent. But this month, Chinese policy makers have stated that Eurozone problems could hurt China’s economy, and continued stimulus might be necessary to maintain growth. This can be a mixed blessing for the markets. In the short-term it’s good news, because it means that China will continue stimulus while Europe is weak and the United States is facing the withdrawal of stimulus. In the longer term, it throws into question whether China can pullback on stimulus without damaging the economy – what many call the “soft landing”. History would suggest that the stronger the bubble, the harder the landing (remember 2008?), so it remains to be seen whether this will be the case in China.

So now we come to come to the crux of all this writing. We have a bull scenario for stocks if the European Debt Crisis can be contained and if China does not seriously clamp down on its economy. This will allow world economies the breathing room to continue their recovery. We have a bear case if Europe’s problems spreads, and an even worse situation if the Chinese bubble bursts at the same time. For the near future, the United States is likely to be hostage to developments in both Europe and China.

The Technicals

Before finalizing our conclusion, let’s take a look at the technicals and see what they say. Here’s the chart of the S&P again.

Technicians are quick to point out a few important points:

The market traded down to the 1040 area, which was resistance back in February. That establishes the 1040 level as support for the current market.

But there is an important difference between February and May. In February, the market remained above the 200-day moving average (red line) and the 150-day moving average. In May, the market crossed the 100-day, the 150-day and the 200-day. Now, the market remains below the 200-day, and in fact, the 200-day is now upside resistance. The market needs to cross to 200-day to establish an upward trend. On Thursday, May 27 and on Friday, May 28, the market failed to push through the 200-day moving average (red line).

The moving averages are beginning to move downward, meaning that the upward trend established in March 2009 is being broken. As of Friday, May 28, the 100-day and the 150-day has begun to slope downward. If the market stayed down at these levels for a few more weeks, the 50-day (blue line) could very well cross the 200-day. This is known as the “death cross” – a decidedly bearish formation.

The technicals are clearly bearish, and while I favor fundamentals over technicals, a large portion of the market analyzes things technically. That means much of the market believes in the technicals, so you have to take the technicals into account.

Conclusions

Putting together the macro fundamentals with technicals, we get a picture that calls for caution. For the market as a whole, we are in a bit of a limbo. The upward trend that began in March 2009 has been broken. The macroeconomic drivers imply a lid on the market – problems that will exert downward pressure on any rally or attempt to establish an uptrend. That downward pressure is likely to arrive in the form of a series of rolling credit downgrades in Europe, as well as economic news from China and the United States that is unlikely to top the optimism of the last year.

The technicals confirm the end of last year’s uptrend as well as continued pressure on the markets. In fact, the technicals imply further downside. From a technician’s point of view, the question is whether we will break below the 1040 support level on the S&P, so this is a level to watch. Whether we fall below 1040 depends, in my opinion, on whether Europe can stabilize its debt crisis and whether China can prevent a burst in its bubble, at least until the United States and Europe have solved the bulk of their problems. Economic news for the United States has been relatively good, but the United States has to move from recovery to consistent growth, even at a low level. All the US needs is for Europe and China to not tip the scales to the downside and for Washington to not do anything that would seriously hamper the recovery.

As I’ve said in past articles, I continue to see 2010 as akin to 2004. Take a look at the following chart of the Dow over the last twelve years:

You’ll see that after the Dot Com bust, the market traded down and finally bottomed in early 2003. Then, we had a major recovery through early 2004 of 45%. The upward recovery was broken in early 2004, and for most of 2004 through 2005, we traded sideways. I think we’ll see a rough repeat of the this pattern. So far, we have a similar bubble, bust and dramatic recovery. In May, the uptrend was broken. I think we’re likely to trade sideways for 2010, and perhaps even for a part of 2011. To be sure, this is not set in stone in any way. I believe it’s the most likely outcome, but we need to keep an eye on conditions that might make us deviate from this thesis.

Implications for the Portfolio. So what’s an investor to do? Obviously, the bulls and the value players are saying buy, buy when there’s blood in the streets. The technicians are saying, wait until an uptrend is established before doing any buying, otherwise stay out of the market. For a technician, that level is at least in the 1110-1120 range. This range is above the 200-day moving average, the low of the Flash Crash, and 1120 is a 50% retracement of decline from the high in 2008 to the bottom in March 2009.

So here are my thoughts on what to do with the portfolio:

If you want to try to bottom fish, you have to be prepared for possible further downside. There are some values out there, but its best not to take any large positions at this time. Better to take a fraction of a position if you choose to go this route. If you want to be technical, best to buy close to the 1040 level, which is support. Keep in mind that there’s no guarantee that the 1040 level will hold.

If you want to be conservative, stay out as the technicians would advise, wait for the uptrend to be established. For the conservative, use rallies to sell out of positions.

In this period, the defensive names that yield a dividend remain the stocks of choice. My current favorites are Kraft (KFT), Altria (MO), IBM and Clorox (CLX).

Make a list of stocks that you’d like to own. I remain positive on Apple (AAPL) on any weakness, and the oil sector is beginning to look interesting. Still, there’s a ways to go with the oil sector. Expect the Gulf disaster to continue to dominate headlines and for Washington to look for ways to punish or tax the industry as a whole. Longer term though, our need for energy will not go away.

I, or my clients, are long KFT, MO, IBM and AAPL.

Disclaimer. All material presented herein is believed to be accurate but we cannot attest to its accuracy. All trades, patterns, charts, systems, etc. discussed in this article are for illustrative purposes only and are not to be construed as specific advisory recommendations. All ideas and material presented are entirely those of the author and do not necessarily reflect those of the publisher. All readers are urged to consult with their investment counselors before making any investment decisions.

No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using the above approaches will generate profits or ensure freedom from losses. The examples used herein are not intended to represent or guarantee that anyone will achieve the same or similar results. Each individual’s success depends on his or her background, dedication, desire and motivation.

The author may or may not have investments in the stocks or sectors mentioned.

As always, I encourage you to consult your own investment advisors before making any investments. I don’t claim to be right; I can only present you my logic, and I hope you will take the time to do your own homework and decide if you agree or disagree with the arguments presented here. Also, if you really feel like spending some more time on stocks, there’s more on my blog at http://minglo.com/investing/.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

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