The Strategic Outlook

Strategic Group · 4380 SW Macadam Ave, Suite 260  Portland, OR 97239 · (503) 222-9737   ·  www.InvestwithStrategic.com

Strategic Group’s e-update

The global economy is showing signs of recovery; however, recent developments have shown just how fragile the recovery could be.  Governments are doing all they can to bolster the global economy, but because of fear investors and some businesses are showing caution and evasive behavior at the first hint of trouble.  Over the course of the last month, news about China and the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) have disrupted the markets.  How does this affect you?

 

The Dow Jones Industrial Average moved mostly sideways from mid-November until the last day of the year.  Presumably that day was a down day as investors cleaned up their investments for the coming tax year (harvesting losses).  There was one period of unrest in the market as investors came to terms with the possible default of Dubai World around Thanksgiving, but otherwise the market appeared to be waiting for the recovery to catch up to the forward-looking stock market before any additional upward movement would take place.  In the first two weeks of January, the bulls started to move and then two things happened that caused investors to flee for safety.

 

Cause One: China and Lending

The first development was the news that China is starting to pull back on lending.  Inflation is starting to rise in China, and because of the currency related pressures that interest rate hikes would cause (see last month’s newsletter about the coming currency war), China instead has elected to slowly ratchet up the reserve requirements for banks.  If banks are required to hold more in reserve, there is less available to lend.  As with the United States and countries around the world, China must find a way to unwind their stimulus package in a measured approach that somehow manages to sustain the recovery while at the same time containing inflation.  Investors probably intellectually agree that reining in the stimulus is needed, but the fear that the one economy that grew by 8.7% in 2009 might be forced to slow its growth, sent a tremor through the market.  This isn’t the first time China has made moves to tighten credit.  Each time, the market reacts negatively for a short time and then realizes that the sky didn’t fall and begins to move forward cautiously.

 

Cause Two: The PIIGS

If you discount the other market moving jitters caused by President Obama picking the day after China’s bank reserve news to propose bank regulations, and Congress choosing the week before Federal Reserve Chairman Ben Bernanke’s confirmation to decide that maybe he wasn’t the right man for the job (with no clear alternative in sight), then the next market quake was caused by the PIIGS.  Although to some extent, each of the PIIGS have similar budgetary problems, Greece created the most market fear.  Their budget deficit is beyond the limits set by the European Union and there may have been some irregularities with previous debt numbers Greece provided.  As a result, their bond issues required higher insurance premiums (via credit default swaps). Also, Greece apparently has a large shadow economy that doesn’t pay taxes.  This last item may not be unique, but it does make it more difficult to balance a budget if a significant portion of the taxpayers don’t participate in the process.  The fear that one of the 16 countries that make up the Eurozone could default roiled the market.

 

The European Union could potentially expel Greece, but it is not clear whether that would solve the problem.  Bonds issued by Greece are held by banks and investors outside of Greece.  So, the European Union must now tackle a problem familiar to Americans.

 

1. “Too Big to Fail?”  Is Greece equivalent to Lehman Brothers?  If Greece defaults, will it create a cascading affect that will weaken the other PIIGS and then potentially investors who hold their debt either directly or through banks in their countries?

2. Can the European Union force Greece into line by placing severe restrictions on it like the TARP rules that were so onerous that our banks would do anything to get out from under the proverbial thumb?

3. If Greece does receive aid, guarantees, or concessions, will the taxpayers who ultimately foot the bill revolt at the need to bailout someone else’s folly?

 

Why does this matter?

For now, the European community has made vague assurances that they will provide assistance to Greece.  The global markets have, if not exactly calmed, ceased the panic sell off.  Greece is taking steps to get its financial house in order.  Since there is no way to tell in the midst of these upheavals if the downturn is short-lived or the start of a new wave of overselling experienced in the last market downturn, we are ready to reduce our exposure to risk and sit in cash to evaluate until the market determines a direction.  Reducing risk will limit some upside gains, but it should also preserve capital if the next “news” upsets the applecart.

 

 

 

We used to think that there were three market directions: Up, Down, and Sideways.  But, we now believe that there is a fourth direction we’ll call Irrational.  Below is a chart that identifies characteristics of each market.

 

Characteristics	Up	Down	Sideways	Irrational
Positive Corporate Earnings	Generally up	Selectively up	May be disregarded	May be disregarded
Negative Corporate Earnings	Selectively down	Generally down	Selectively down	Generally down
Positive Economic Data	Generally up	May be disregarded	May be disregarded	May be disregarded
Negative Economic Data	May be disregarded	Generally down	Selectively down	May be disregarded
Mixed Economic Data	May be disregarded	Generally down	May be disregarded	May be disregarded
Direction change	Upward until some trigger event changes direction	Downward until fear subsides or the trigger event is neutralized	Within a box range until the perceived valuations equalize	Up and Down
Duration	Weeks to years	Weeks to years	Weeks to months	Days, weeks, months, or longer

 

Clearly, the irrational market is a difficult one to navigate.  Earnings and economic data are always subject to interpretation.  Each piece of data has both a good news and bad news component.  If the dollar gains in value, imports will rise benefiting foreign investments and weakening U.S. exports.  If U.S. companies are reporting fast growth and higher earnings, then inflationary pressures may be increasing.  It is not always possible even in hindsight to determine what caused a change in market direction.  Time is the great equalizer, but in an irrational market, the duration of the movement may be driven entirely by fear or greed – both of which are volatile emotions.  We believe the last several weeks were a return to the Irrational Market.  At the end of last week, we saw signs of a return to normalcy.    Fear of a return to the Great Recession still lingers.  Assuming that no new stories appear to heighten that fear, we should return to one of the three typical market directions.

Clearly, the irrational market is a difficult one to navigate.  Earnings and economic data are always subject to interpretation.  Each piece of data has both a good news and bad news component.  If the dollar gains in value, imports will rise benefiting foreign investments and weakening U.S. exports.  If U.S. companies are reporting fast growth and higher earnings, then inflationary pressures may be increasing.  It is not always possible even in hindsight to determine what caused a change in market direction.  Time is the great equalizer, but in an irrational market, the duration of the movement may be driven entirely by fear or greed – both of which are volatile emotions.  We believe the last several weeks were a return to the Irrational Market.  At the end of last week, we saw signs of a return to normalcy.    Fear of a return to the Great Recession still lingers.  Assuming that no new stories appear to heighten that fear, we should return to one of the three typical market directions.

Four Market Directions

The Global Economy: What’s going on and how does it affect you?

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