The purpose of my quarterly news letters is to provide my tax, real estate and home mortgage clients with a unique “outside the media” perspective on current market issues and developments. It is not to be considered a substitute for retaining personalized planning from investment and legal professionals.
In my last newsletter I advised you to “sell in May and go away.Since my “spring call” the S&P had dropped nearly 20% before its recent 12% rebound. What’s next? Is this a good time to invest? Yes, but not before you read the fine print below!
“Too big to fail – too big to bail”
is the latest journalistic slogan to describe the upcoming episode in the European economic contagion conundrum with regard to Spain and Italy. Make no mistake about it, a European failure is bound to have huge ramifications for U.S. and global financial markets.
I first wrote about the Greek tragedy over a year ago, and had to renew warnings yet again last spring when I advised to sell equities in “May and go away”. As the end game of this saga hopefully approaches I should entitle this epistle “Stay Away,” especially so if you can’t stomach another 10% drop in the market. However, the next European inspired downturn is too much anticipated and therefore unlikely to precipitate a fall below the recent Sept. lows. A Greek default (politely referred to as “restructuring”) on its 450 billion of sovereign debt is certainly near. Its socialist government has done absolutely nothing in the past 12 months to implement the sort of structural change necessary to solve their insolvency. According to Athanasios Papandropoulos, a leading Greek economist, “In these 12 months it has not fired even one civil servant. The only thing it is doing is to tax the private sector out of existence. Why should we believe they should do something different now?” Greek newspaper Kathimerini published the following: “Whereas more than 1,000 Greeks were losing their jobs in the private sector every day in August, the government was assuring civil servants with lifetime tenure that their job privileges were not in danger.”
In the past year and Â½ not a single privatization has taken place as Greek politicians are loath to give up the system of spoils that they have long run in exchange for votes from members of public sector unions. The market may rally if the latest 8 billion installment of the $147 EU bailout is made but the core problem is the 20% gap between average worker’s productivity and the average wage. So the more Greeks work, the deeper in debt they go! The Greek 10-year bond is trading at 40 cents for each dollar of face value. Greece requires structural and political change that only an absolute meltdown can inspire.
The latest news to rally the market is the promise from Angela Merkel and Nicolas Sarkozy to “thrash out their differences over the eurozone’s rescue fund by the end of October.” Never mind that 17 governments may have to approve whatever they “thrash out.” The press is floating a 2 trillion leveraged (insured) backstop for EU governments. This is easier said than done. Market action suggests that the European banking system is too weak to handle even an organized default. The recent failure of Dexia which passed the recent European bank-stress tests is only the most recent canary pulled dead from the coal mine. European banks are all exposed to the $2 trillion sovereign-debt market for Greece, Ireland, Portugal and Spain and have yet to fully recognize likely losses on their books. Again, these problems are likely to wash up on our shores as well as the U.S. money-market industry still has somewhere over a trillion dollars of direct exposure and the Bank for International Settlement reports that American banks have loan exposure to German and French banks of more than $1.2 trillion. European political leaders are expected to require European banks to come up with $100 billion Euros of new capital to prevent such contagion. This will, of course restrict bank lending and further depress economic recovery. Yet, we must keep in mind that Europe is financially capable of solving these problems if they can muster the political will and austerity to do so. They are simply arguing over the bill. Bottom line: as investors (in the words of the famous Strauss-Kahn) we can count on Europeans to act “either too little or too late, or too little and too late.”
The good news is that the “spring-to-summer” economic slowdown seems to have dissipated and is showing signs of a healthy “bounce.” After flattening earlier this year, real personal consumption is on pace to rise more than 1.5 percent in the third quarter, weekly retail chain store sales have remained robust, and the annualized U.S. auto sales rate has risen by more than 14 percent since June to 13 million. Weekly unemployment insurance claims remain in the low 400,000 range, reported private sector ADP employment gains have averaged 100,000 in the last two months and layoff announcements have remained subdued. Corporate profits remain high, industrial production posted back-to-back gains in July and August and factory orders and durable goods shipments have likely accelerated.
In August and September, the Dow industrials rose or fell by more than 1% on 29 days, and there were 15 days with final moves of more than 2% leaving the average investor fed-up and out of the market. The last time the markets saw that kind of volatility was in March and April of 2009 just before taking off on a 6,000 point run through April of this year. Remember sell-offs should be looked at as an opportunity, not a catastrophe! Equities are over-sold and remain cheap! Traders are making money buying every dip and selling every rally. If you try this with a small portion of your portfolio the reward may well be worth your risk. Remember, the best time to buy is when there is blood in the streets. A good number of market commentators are expecting a rally from here. Just be careful not to get shot! A safer strategy would be to dollar cost average by entering the market with small purchases after sell-offs every other week over the next six months or so. Economic fundamentals and especially consumer confidence are likely to be better a year from now, and by then the worst of the European contagion fears should have played out to one end or another. As long as our banking system remains sound our economy will likely grow despite European stagnation.
Adding fuel to the fire: Spanish socialists lost big time in regional and municipal elections. Why is this news important? Because the Spanish economy is the world’s 12th largest dwarfing that of the other PIGS with debt of nearly two trillion. Recall that the full extent of Greek debt problems did not come to light last year until newly elected officials swept under the rug and found millions of euros of off balance sheet debt. Worry is the situation in Spain will prove deja vu. There is nothing Europe fears more than the necessity of a Spanish bailout which could reach $350 billion. Opposition to austerity measures has already toppled governments in Ireland and Portugal is Spain next?
What else has gone wrong? More than I have time to relate. Here are some of the headlines: Japan’s (world’s third largest) economy contracted over 3% during the first quarter; China (world’s second largest economy) raised interest rates for the fourth time last month to 6.31% to counter an inflation rate of 5.3%; They raised their bank reserve requirements to 21% (the eight increases since October;) Their May purchasing manager’s index was the lowest in 10 months; Consumer spending growth was recently revised down from 2.7% to 2.2%. Meanwhile, Chinese Yuan money supply and outstanding loans reached the lowest pace in 29 months; Last week’s Institute of Supply Management released an early-warning signal regarding new orders and inventory rose 8.1 points vs. 15.9 in March; U.S. commodity exchanges have raised margin requirements which has cooled speculation in oil and silver – they undoubtedly did this for an old fashion reason: when the music stops, and speculators scramble for chairs, they want to be paid! The Euro has dropped 5% against the U.S. dollar this month – every time the dollar has strengthened over the past few years it has correlated with a drop in the major market averages.
Real estate update: The bad news is there’s no market recovery. The good news is that we’re not taking a double-dip in sales. Purchases of existing homes dropped 0.8% to a 5.05 million annual pace last month. The median sales price fell 5% last month to $163,700. According to a survey taken by Trulia Inc. and RealtyTrac Inc. 54% of respondents don’t expect a recovery for at least three years. The number of previously owned homes on the market rose to 3.87 million a 9.2 month’s supply at the current sales pace. Interestingly, distressed sales, which comprise foreclosures and short sales accounted for 37% of all homes sold. Other data demonstrate that at these levels investors are moving in to support the market from falling much further. For instance cash transactions (a necessity for many investors) accounted for an astounding 31% of over all sales.
Isn’t the U.S. recovery strong enough to overcome these negative headlines? Absolutely, I wrote in my last newsletter, I expect the economy to continue to improve despite these “soft patches.” I’m just saying if there doesn’t appear to be a compelling reason to invest, amid so much negative news, why not sit on the sidelines, let the volatility pass and preserve cash? Two events that could prove to be game changers would be true, permanent resolutions of either the European or U.S. debt outlook. For instance, if we end up with a bipartisan U.S. budget resolution this summer that appears to permanently improve the outlook for future deficit reduction that, to me, might be a compelling reason to move back into equities. Whatever happens, if the market does sell off 10% don’t wait for your CPA’s permission to reinvest. You should always run my calls past your financial advisor and when you do move into and out of the market do so in stages – not all at once!
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