Unanswered Prayers

Looks like our prayers (“Sell in May and Pray”) are not being answered as the risks of a sustained market correction have not abated but seem to have expanded.

While many have focused on the risks of contagion emanating from Greece to other vulnerable European markets and eventually to the US (a very real concern, to be sure), the greater risk to a sustainable recovery appears to be more substantial and involves the political realm – a factor that is all too often minimized in most investment strategy and portfolio management analyses.

The willingness to “kick the can down the road” and not address the risks that years of accumulating bad debt pose may be the only viable alternative to a bad situation. Case in point is the solution offered to backstop the entire bad debt environment in growth-challenged Europe. The net result will be a substantial reduction in growth in one of the three major economies of the world (they being Europe, the US, and Asia).

Some would argue that global growth really doesn’t need Europe – as long as contagion doesn’t become a reality. This is foolish and quite simplistic thinking as (a) it is very large consumer market and (b) the risks of a political contagion are more worrisome.

At a time when the macro risks to the global economy keep rearing its ugly head 3 YEARS AFTER THE CRISES BEGAN requiring constant political intervention, often against the will of a majority of its citizens, just how deep and pervasive the bad debt and financial system run amuck problem is.

To illustrate just how troubling the situation has become, consider the following from the Associated Press reported on Monday, May 17, 2010: “The European Union will draft new rules to tighten oversight of derivatives markets and set new fines for manipulating trades in complex financial instruments that some blame for worsening the financial crisis.

EU Financial Services Commissioner Michel Barnier said Monday that regulators had to know more about derivatives and the investors behind them. He would demand all products and trading to be registered with trade depositories that regulators could access.

"These people don't like coming out in the light so we are going to flood them with light," he said.

The $600 trillion sector is largely unregulated at present, with many trades taking place privately between investors. Derivatives are financial contracts that do not require a trader to own the underlying security or financial asset. They include swaps, options and more complex instruments.

Barnier said his proposal, due in late July or early September, would cover "all eligible over-the-counter derivatives markets" - those which don't operate on an exchange - and include capital and liquidity requirements. He gave few details on specific limits that the EU would set.”

The failure to get one’s arms around the key macro issues at work – economic and financial – threaten the sustainability of global growth at its core. Expectations that the positive cyclical trends at work lifting the global economy out of recession will result in an ability (and willingness) to address the longer-term structural problems is at heart of the “kick the can down the road” mentality of most investors. Whether there will be the political will to address the problems of today pushed out to tomorrow is dubious at best.

Moreover, areas of the global economy in the developing economies – specifically China – will help sustain the cyclical recovery. However, relying on a country that bases its growth almost entirely on fixed investment spending and exports is a very risky proposition.

Investment Strategy Implications

A raft of issues – many in the macro arena – does not bode well for a fully valued stock market contingent on growth from a country (China) whose stock market is signaling something is not quite right (see accompanying chart: China (FXI) versus the US). Expecting the US consumer to sustain his/her recent spending spree is also naïve, deleveraging has not left the building.

With a global economy that is decelerating, the US consumer deleveraging, and governments delaying, a key question to consider is, “How many cans being kicked down the road can the world economy withstand?”

The prudent course of action is to move to a more risk averse posture (i.e. a lower stock market exposure), letting the damage of two weeks ago work itself out. A rally should then ensue, the quality of which will reveal if this bull market is about to end. Until then, a reduced equity exposure is advisable.

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