Stock Market Investing From May to November Fraught With Danger

Stock markets are set for a roller coaster ride this week. While strong 1st quarter profits were reported and the US economy grew 3.2% in the first quarter, slightly short of economists’ forecast but still made for a third consecutive quarter of growth, investors were spooked by lingering doubts on the viability of Greece’s financial rescue.

Two months of wrangling on the terms of financial aid was brought to bear as Greece received a bailout of €110bn over 3 years, sponsored by the EU-IMF. The olive branch was expected after Greece’s close brush with bankruptcy last week. All hell broke loose after European Union revised upwards Greece’s 2009 deficit to 13.6% of GDP and rating agencies downgraded its credit to junk status, limiting access to fresh funds.

The first disbursement of bailout money will be made before May 19 to avert a default, but there is no guarantee financial stability will prevail in the eurozone. If Greece bite the bullet and persevere to put its finances in order, they will face a recession and deflationary pressures which will cripple their economy for years.

However, given Greece’s abysmal record in fiscal discipline, it is doubtful if the austerity measures will be implemented fully. Greece promises to cut its budget deficit to 3% of GDP by 2014, but reining in spending is a tough call, with mounting political pressure from rioting workers and pensioners. From the initial response, a deadlock may ensue and hold the economy to ransom which essentially defeats the purpose of a bailout.

It is ironic that with this bailout, bond vigilantes have shifted their scrutiny to other debt laden nations in the Euro zone. Greece is but the tip of the iceberg, they came first to the party with hat in hand and are now safe, at least for a year. A dangerous precedent has been set though. How can Europe not save Portugal or Spain after handing Greece a lifeline?

Besides the PIGS (Portugal, Spain, Italy, Greece), you can count Austria, Belgium, Hungary, Ireland, and UK in the soverign default risk category. US and Japan have worrisome debt to GDP ratios too but because the former possess a reserve currency (licensed printing press), while the latter has a springwell of domestic savings to tap on for cheap government loans, their financial woes are not expected to blowup any time soon.

And since we are talking about irony, it is worth mentioning that the sovereign debt crisis is set to boomerang back to the banks which started the financial crisis with their reckless and greedy behavior. To prevent a total collapse during the darkest hours of the mayhem, European banks transferred toxic assets from their balance sheets onto the states, which were deemed better able to absorb such risks. Countries also adopted loose monetary policies to jump start their moribund economies. Add in lower tax revenues to these Keynesian efforts, the result is astronomical budget deficits.

The fact that European banks hold a lot of Greek, Portuguese, Italy and Spanish debts is not lost on investors, especially the ‘shorts.’ If these countries default, the banks will definitely require another round of capital raising to bolster their balance sheets. But what if capital markets froze again and unlike 2008, you can’t bank on another bout of taxpayers’ rescue as fiscal budgets are already maxed out?

I hate to say this but financial Armageddon awaits Europe. As a monetary union, you have to sink or swim together. If more countries start asking for bailouts, the entire euro zone will face higher interest spread, and the euro could be non-existent if the political limitations of euro zone are not fixed.

Seeing how Europe struggles brought back memories of the Asian financial crisis in 1998. Not surprisingly, “Sell in May and go away” strikes a chord with many investors. The cliche does not always apply but it is a good rule of thumb. Historically, stock investing during the period from May-November is fraught with danger or at best rewarded with meager returns. Moreover, with a remarkable gain in the stock market (S&P having risen 75% since bottoming out in March 2009), it is time for a considerable pullback.

To be sure, a lot of positive news had been priced in amid the stock market rally. The V-shaped recovery and optimistic valuations appear realistic to many investors despite unfavorable aspects like high unemployment, rising debts, higher taxes, etc. While not exactly in a stock market mania, investors have cast aside their fear.

Thankfully, the stock market decline recently may keep our feet firmly on the ground. This is a time when investors should review their portfolios and make adjustments by offloading deadweight, shifting into defensive sectors and putting stop losses into place.

Usually, when investors shun stocks, they head for bonds market which are considered safer investments. You get a fixed income annually and if you hold it to maturity, you get back your principal. But bonds suffer from interest rate risk.

In the past, bond prices had plunged by 20-30% when interest rates double. As the US bond market is much larger than the stock market, many “risk averse” investors are going to feel poorer due to the losses from their fixed income assets.

When will Ben Bernanke raise interest rates is unclear but if futures on federal funds is any indication, the zero-rate policy is likely to be abandoned in November or December. Indeed, with the economy on the mend, Ben Bernanke has little excuse to delay raising interest rates and combat inflation. We may even see hyperinflation by 2012, thanks to energy/commodities which are in a secular bull market and the Fed’s misjudgment.

If you still favor bonds, you should go for short term Treasuries (3-6 months) because the longer the maturity date of your bonds, the higher your losses if rates surge. Right now, anything more than 2 years is a dangerous bet.

In the stock market, rising rates which translates to a higher cost of capital, will be detrimental to businesses but especially so for financial, property and construction counters. With higher instalments, investors will think twice about purchasing houses. The effect of lesser buyers coupled with desperate sellers who are on floating rate mortgages and about to reset higher will not be kind to the property sector. REITs, if they happen to have excessive debts and require refinancing, will also be tested once interest rates increase.

As for China, it is losing its lustre as a get-rich-quick destination right now. The government has clamped down hard on property speculators, restricted hot money inflows and outflows and it may yet raise banks’ reserve ratio requirement for the nation’s banks to 18%.

All these measures are calibrated to burst the bubble and yield benefits in the long term, but in the short run, nobody knows if the pendulum will swing too far and result in a second dip. Thus, parking cash in yuan, hoping there will be an appreciation, is not a sure bet if the Chinese economy cools down drastically.

Under such circumstances, gold remain the favorite asset for investors who love a safe haven. Even if gold achieved a year high of $1169, there is more upside to go. The frenzy which ensues from a Europe collapse will only add to gold’s appeal. And with the ongoing debasement of US dollar, gold has no direct competitor when it comes to preserving our purchasing power.

You can print out trillions of dollars to pick up the slack in the private sector or distort market machinations but you cannot change the primary trend which shows that stocks are in a secular bear market. Stock market can go up higher or lower but it has to come back to its equilibrium, say Dow Jones Index of 10,000, which is why some astute pundits have pointed out that this round figure is nothing to crow about and we will see more of it before the whole episode is over.

As I mentioned in my last post, this is not a year to attempt speculative activities and buying stocks aggressively is a dangerous approach. However, I do encourage buying on the dips, say after 10-15% correction. We have not seen the worst of the carnage which will probably gain momentum in June but if it is any consolation, there could be a rebound in early 2011.

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