Q2 Outlook: Straw On The Camel’s Back

The U.S. stock market posted strong results in the first quarter of 2013.  But what is perhaps more notable is that U.S. stocks were essentially alone in this advance.  Many non-U.S. stock markets fell for the quarter including the Euro Zone and Emerging Markets.  The investment grade bond market also edged lower and high yield bonds, which are highly correlated with stocks, were only incrementally higher.  And the precious metals including gold and silver sold off during the quarter.

What was perhaps more notable is that U.S. stocks pushed higher on their own despite considerable fundamental headwinds that would otherwise be expected to favor the bond and precious metals markets at the expense of stocks.  U.S. economic growth readings remain mixed at best and are slowing in many other parts of the world including the Euro Zone, which is already in recession.  And corporate earnings growth has not only declined on a year-over-year basis already over the past two quarters along with a rolling over of profit margins, but forward earnings projections have also been revised lower by -6% over the past year.  Never before have we seen U.S. stocks post such an advance amid declining corporate earnings growth and profit margins at this late stage of an economic cycle.

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Of course, the U.S. stock market has been rising since the beginning of 2013 for one key reason.  On January 4, the U.S. Federal Reserve added daily Treasury purchases to its QE3 stimulus program.  And since that time, U.S. stocks as measured by the S&P 500 Index have risen on 64% of trading days, which is a +6 standard deviation event.  In other words, the daily stock market behavior witnessed in the first quarter is supposed to happen only once every 506 million years.  Clearly, the influence of the Fed on the U.S. stock market is strong.  But is it sustainable?

This is the key question as we move into the second quarter.  While U.S. stocks have continued to show resilience in the first few trading days, they are incrementally lower for Q2 to date.  And in each of the last three years in 2010, 2011 and 2012, the stock market opened the year strongly in Q1 only to plunge into a double-digit decline starting in April and extending into the summer.  With stocks already widely disconnected from fundamentals heading into April 2013, the potential for another sharp pullback is more than a reasonable possibility.

But one important fact differentiates the stock market in 2013.  In each the past three years, a major central bank stimulus program was either ending or was drawing to a close in the month of April.  But this is not the case in April 2013, as the Fed has committed to continue QE3 for as long as it deems necessary.  As a result, it is also more than possible that stocks can defy expectations and continue to rise further in the months ahead, even if underlying fundamentals continue to deteriorate.  This is particularly true given that the Bank of Japan recently announced a massive stimulus plan of its own.  More on this in a moment.

Despite the recently good feelings for stocks generated by monetary policy, what may ultimately stunt if not completely derail the recent stock advance are the mounting structural problems that continue to breakout across the globe.  In short, the probability of a destabilizing financial event is rising, and if any such episode induces major global financial instutitions to retrench on risk assets to protect their capital position, the subsequent decline in stocks could be swift and sharp even with the Fed’s endless support.

This leads to the critical question as we enter the second quarter.  What if anything will be final the straw that breaks the camel’s back and shakes financial markets back to reality?  The following are some leading candidates in the months ahead.

Cyprus Spillover:  While the banking crisis in Cyprus has moved from the headlines, its effects are only beginning to be felt.  The final outcome of the Cyprus debacle was that uninsured depositors with over 100,000 euros in Cyprus banks ended up taking significant haircuts to secure the bailout deal.  And while the media cameras showed no evidence of bank runs in Cyprus once these institutions reopened, nobody expected the oligarchs and other major international depositors to get in line along side the average Cypriot citizen to withdraw their money.  Instead, these are individuals, corporations and foundations from around the world that are likely to be meeting in the coming weeks to discuss among other things whether it continues to make sense to maintain sizeable bank deposits in places like Greece, Portugal, Spain and Italy where the risk of taking a major deposit haircut has now risen substantially.  We are already seeing evidence of banking stress emerging in places like Slovenia, Malta, Ireland and Italy, and the more depositors opt to withdraw deposits, the more creeping electronic bank runs have the potential to pick up speed in the months ahead.  At minimum, this situation merits monitoring going forward.

Japanese Stimulus:  Japan is the world’s third largest economy and has been mired in a two decade long depression marked by seemingly unshakable deflationary price spiral.  New political leadership took over late last year with the commitment of finally shaking the Japanese economy back to life by creating inflation with a target 2% rate.  And keeping with this promise, the Bank of Japan announced late last week its monetary stimulus program that vastly exceeded already aggressive expectations including an extraordinary doubling of its asset base in the coming years.  But here is an illustration of one of the many key problems associated with this plan.  The Japanese 10-year government bond yield is currently 0.52%.  Yes, for every $1,000 you lend to the Japanese government, you receive $5.20 each year over the next ten years.  Quite a deal, and these Japanese yields have been exceptionally low for some time.  But if the Bank of Japan achieves its 2% inflation target, it means that everyone that owns Japanese debt will be left with holdings that provide a negative real yield (this of course assumes that they will be able to stop the rise at 2%, which will be a feat in and of itself).  And what are investors going to do with their Japanese bonds if they are suddenly an investment that is generating a real loss?  They will likely sell these bonds, perhaps aggressively.  Given the fact that the total public debt in Japan is 219% the size of the entire Japanese economy as measured by GDP, achieving the desired 2% inflation target if not much more has the potential of inadvertently collapsing the entire Japanese economy.  Thus, how events unfold in Japan currently present a major risk to the global financial system.

These are just a few of the many risks that global financial markets are currently navigating.  And while the fact that U.S. stocks are showing resilience in the face of these challenges is impressive, it is also disconcerting to a degree.  This is due to the fact that the lack of any reflex to negative news developments indicates a stock market that has effectively become disconnected.  And in such a state, just as stocks can rise beyond all comprehension without fundamental support, so to can they fall dramatically and persistently without seemingly any real reason.  As a result, while maintaining an allocation to stocks certainly makes sense in the current environment given the still strong upside momentum, any considerable overweights to the stock market are associated with far more downside risk than upside reward at this point.

Fortunately, capital markets offer a variety of asset classes to realize positive returns regardless of what stocks are doing at any point in time.  And a number of these categories stand to directly benefit if the stock market enters into correction for the fourth year in a row this April.

Leading among these is the precious metals market.  For as much as stocks have been artificially elevated thus far under the Fed’s latest QE3 stimulus program, precious metals including gold and silver have been artificially suppressed.  But knowing that the laws of supply and demand have not been repealed and that prices will eventually find their way to their true equilibrium over time, steady worldwide accumulation trends along with the fact that short interest is now at historically high levels for both metals suggest that both gold and silver have the meaningful potential to slingshot higher at some point in the coming months.

The bond market is also showing renewed life following a period of weakness over the past few months.  Ironically, the Fed QE stimulus programs that are supposed to result in lower interest rates have typically ended up producing higher interest rates, and the experience during QE3 has been no exception in this regard.  But this effect typically wears off after the first two and a half months following the start of a Treasury purchase program, as institutions retrench following the initial risk asset buying spree.  This timing has also held true under QE3, as the bond market rally kick started in mid March roughly two and half months after the Fed began purchasing Treasuries in early January.  And as long as history continues to provide a reasonable guide, the bond market generally and long-term bonds in particular have shown the propensity to advance strongly higher once the stock market enters into correction.

It promises to be an interesting few months ahead in the second quarter.  I will be checking back with periodic updates along the way as events warrant.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

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