Market Perspective for 7/16/12

July Unemployment: Fourth consecutive disappointing report.  The trend is confirmed.  This is going to put pressure on the Federal Reserve to come up with something, though nobody is really sure what they could do.  The “half-life” of any central bank action has become very short now, as so many moves by the European Central Bank, the Fed, China, and Japan have produced less and less.

Stocks: I thought we’d see a better entry point and we have, but I’m still thinking stocks will grind lower.  Second quarter earnings are beginning to come out and while they have been decent, future guidance is taking a hit.  Companies are blaming Europe and increasingly China as well.  Small caps have held up fairly well because on average less of their sales are overseas.  If it is believed that the U.S. will go into outright recession, however, small caps will surpass on the downside because their balance sheets and valuations are worse (by and large).

International concerns are moving markets the most on a daily basis.  We are in a pattern where the market falls or jumps based upon news out of Europe, and then fades in the afternoon after the pros trade the move.  It is difficult for me to see a scenario in which the market falls off a cliff.  The fact is, most corporations have excellent balance sheets right now.  Do you really want to sell the stock of McDonald’s (yielding 3.1%, earning enough to cover the interest on its debt more than 17 times over) and buy a ten year U.S. Treasury (yielding 1.5%, where debt-to-GDP is approaching 90%)?

Bonds: I have to apologize for not being bullish enough.  Sure, I chided the pundits for repeatedly predicting that inflation would soar.  I made the mistake, however, of believing that we were in the eighth inning of the bond bull market (so to speak), such that it was too late to put new money into bonds.

What I neglected to consider is that we are in a secular bear market and that as such, one’s primary concern must be return of capital as opposed to return on capital.  How else can one explain that Germany today sold 2-year notes at a yield of -0.021%?   The U.S. T-bill rate went negative briefly during the worst of the recession, but T-Bills are only 3 months.  There is so much fear in Europe right now that people are willing to pay just not to lose money.

Europe: By and large, Europeans prefer fixed income securities to equities.  Americans and other foreign investors prefer not to have European exposure at all.  Many stock speculators are net short Europe.  So you wind up with some very cheap stocks with generous yields.  That doesn’t mean, however, that they won’t get even cheaper.  If you have patience, the total returns from European stocks could rival anything else in the investment universe.

China: The slowdown continues.  The question for investors is hard landing or soft landing.  Most strategists have been in the soft landing camp, but the earnings guidance from companies like Cummins in the last few days would suggest that hard landing is a very strong possibility.  China has sharply reduced its importation of raw materials, putting downward pressure on commodities.  This makes it further unlikely that we will see inflation anytime soon.

Strategies that are working in this environment:

1. Being long the U.S. Dollar (UUP)
2. Being short the Euro (DRR)
3. Being long defensive stocks (SPLV)
4. Investing for yield (utilities & real estate – both of which are overvalued)
5. Long duration bonds (VCLT & TLT)
6. Floating rate debt (EAFAX & HFLAX)

Historically, summer trends have a habit of remaining in place until just before Labor Day.

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