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 look past the Euro-PIGS crisis, the falling U.S. dollar, political gridlock, persistent joblessness and a moribund real estate market and anticipate private sector growth, improved industrial production and consumer spending, a stronger economy and continued stock market performance. Since my “fall call” the S&P was up 13.25 through May 1st. Since then, it has dropped 3%.
Is it time again to “sell in May and go away?”
That’s the call I made last May. My intention was to encourage you to take a break to avoid any panic selling during the down draft caused by the Greek crisis and other negative headline risk. I now repeat that same call for those of you who can’t stomach a 10% drop. Same issue again this year. What happens in Greece will not stay in Greece. Here are the latest sad developments which some feel could eventually end up creating a eurozone rival to the 2008 U.S. contagion resulting from the Lehman collapse. Last May I expressed the view popular among those in the know that Greece will ultimately default on its government debt. To postpone the inevitable, last year, the EU and the IMF threw Greece a $155 billion lifeline. They have since provided over $225 billion to Ireland & Portugal with Spain now waiting in the wings. In return they required Greece to do a lot of belt tightening which has predictably caused the economy to contract. Their debt is now projected to reach $528 billion and change by next year. Current market prices for Greece’s ten year bond reflect yields exceeding 16% and the other PIGS borrowing costs are not far behind. In essence further borrowing is quickly becoming a non-option. Which is why the European Central Bank has been buying their debt for months as their sole lender of last resort. Last week German and French politicians began seriously floating the idea to “reprofile” Greek debt. Not to be confused with “restructuring” or forcing bond holders to wait additional years to be paid back. To “reprofile” is to allow bond holders to come forth to volunteer to wait more years to be paid their principal. The idea being that European banks (the bondholders in question) might agree to do this to avoid “restructuring’s” triggering credit default swaps. Remember it’s not only the debt default that creates losers. It is also the banks and insurance companies and others who are insuring this debt or taking one side or the other on interest rate swaps. The ECB has effectively vetoed “reprofiling” stating it “could trigger a credit event” with unpredictable consequences, and that the ensuing contagion would prevent the ECB from further purchase of government debt. I will spare you the numerous theories of financial apocalypse cropping up these days in the financial press. Suffice it to mention not good for Nervous Nelly equity investors. Greece will sell off assets to reduce its deficits and the eurozone may successfully kick this can on down the road, but for the interim volatility in the Euro will negatively affect equities.
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!
Question: What happened to talk of a “bond bubble?”
We still have historically low interest rates. What’s next?
Everything I said about bonds and interest rates in my last newsletter held true for about three months, then reversed. Since mid-February rates have reversed the climb I predicted and come back down to historically low levels. Bond buyers last week drove the yield on the 10-year treasuries below its 200-day average to 3.08, near its lowest level in six months. Obviously my statement that rates were “mathematically unlikely” to trend lower was premature.
The yield on the 10 year Treasury did rise from 2.66 on November 1st. to 3.64 by February 1st 2011, but it has since dropped back down to 3.15. A continuous selling of bond funds did not occur as expected. In fact, investors pulled nearly $5.8 billion from U.S. stock mutual funds in May, while steering more than $16.5 billion back into bond funds even as yields waned. The exact opposite of what I expected.
Was my prediction right but early, or just plain wrong!
There has been much discussion as to what is going on in the bond market, but no convincing answers in my opinion. Many point to Federal Reserve buying under their QE2 program. Some expect rates to jump once that program ends at the end of June. On the other hand is it possible that the bond market is anticipating the slowing of the recovery suggested above? The recent sell-off in commodities and the strengthening of the U.S. dollar fit nicely in place if this view proves correct. Only time will tell, but I hold by my analysis that eventually any intermediate term soft patch will be overcome. If so, these historic low interest rates are not likely to last and inflation should ultimately drive investment dollars back into the stock and real estate markets.
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