Markets Currently Held Hostage by European Politics

Thu, Oct 20, 2011 - 9:46am

The financial markets are like any infant, attracted to the newest shiny object. The shiny objects have ranged from “good” earnings in the banking sector – primarily due to changes in reserves for loan losses to various comments from the European leaders about bailout plans. Little attention has been paid to the underlying economic data or valuation levels of various stocks. If investors are not tuned into the global markets and paying attention to the various “leaks” on debt bailouts, they’ll be left scratching their heads over the subsequent market movement, wondering what just happened. So what are investors to do in this type of market that routinely ignores economic and earnings data and focuses instead upon the various comments for politicians around the world? The comparison might be playing a game bereft of rules, why bother playing? Reducing overall equity exposure, increasing cash and short-term bond holdings make sense, at least until the markets begin to “play by the rules”.

It may be instructive to look at some of the various industry groups or asset classes to help determine the longer term “risk trade”, whether off/on or undecided. First up is a relatively straight forward chart – to buy stocks or bonds. Stocks, as represented by the SP500 and bonds are represented by the Barclay’s Aggregate (formerly Lehman Agg). The chart below is a comparison between the performance of the SP500 and the Barclay’s Aggregate. The smoother line is a 25 period average. If the line is rising, bonds are performing better than stocks; if the line is falling, stocks are performing better than bonds.

Click here to enlarge

After a long period of stocks performing better than bonds (’03-‘late ’07) and the equity market collapse, when bonds trumped stocks into the March ’09 bottom and stock market rebound into ’10, the tug-of-war between stocks and bonds has been violently occurring over a much shorter time frame. This change in the characteristics between the two “major” asset classes is one of the reasons for the consternation with investors. Rotation between the two has been coincided with the sovereign debt “announcements” from high/likely defaults to solutions being floated via “leaks” or attempts at putting together a more permanent solution. The key here is not that sovereign debt is the problem, as that has been well known for two years, but that the solution is likely to be a political one and not a “market” solution (default/recapitalization). Since politics has entered the fray, it is little wonder that markets have gotten more volatile, both on an individual basis as well as relative to each other.

So should investors “diversify” overseas? Whether looking at emerging markets or the EAFE index, both have underperformed the US markets, emerging markets since late ’10, and EAFE since mid-’07. The combination of debt problems, slowing economies (in emerging markets) and the surprisingly strong dollar have all conspired to keep international investing a rough ride. Many would argue why bother investing overseas, when many of the largest and most global companies are right here in the US? Here again, the dollar could have an impact upon the earnings of many of these companies. We have already heard from J&J as well as IBM commenting that the stronger dollar has impacted earnings in the third quarter. Unfortunately, the early read on the fourth quarter is for more dollar strength. For example, using the trade weighted dollar index, the quarterly change in the dollar moved from a decline of 4% in the first quarter ’10, to a decline of 1.75% in the second quarter to a gain of 2.23% in the third quarter. Why additional strength in the dollar? Once again sovereign debt is the answer. In this case, investors have been fleeing to the dollar as problems unfold in Europe. Yes, we have plenty of problems, but on a comparative basis the US remains a haven.

So bonds are a decent investment instead of stocks, but are getting whipped sawed on a daily/weekly basis, making this investment a tough one to time. International investing has been tough as global slowing and a stronger dollar have conspired to push returns vs. the SP500 down.

So the domestic market looks to be the best place to be, at least compared to sending money into the international markets. What parts of the US markets look best? Here again, we’ll take a look at the relative performance of the various Spider ETFs that make up the SP500. A quick review of the sectors: basic materials have been weak most of this year, falling hard in August and September as metals, especially copper prices, declined sharply during the period. While not as deep as the decline in late ’08, the decline in this group, as compared to the SP500, has been just as steep. Energy has been volatile, falling against the SP500 for all of ’09 and much of ’10 before QE2 was announced. Energy then did very well vs. the SP500 into the first quarter and has bounced back and forth since. The other deep cyclical group, industrials, has had a more defined move against the SP500. The group fell through ’08 and bottomed with the market in March ’09 and began to outperform the SP500 through the first half of this year before falling against the market hard during the July/August period. So looking at the most cyclical portion of the market and most sensitive to domestic as well as global growth, performance against the popular SP500 benchmark has been severely lacking.

The better relative performance is and continues to be ensconced in the defensive parts of the market, from staples to utilities and technology. While technology has been dominated by heavy weights in Apple and IBM, recent earnings disappointments may force the group to take a temporary step back. The message of the markets continue to be capital preservation and playing defense in a very volatile market that has been held hostage by a political environment rather than one focused upon earnings and economic data.

About the Author

Managing Director
pnolte [at] dearpart [dot] com ()