Volatility Still Rules, But Should We Be in Cash?

 |  Includes: DIA, EEM, QQQ, SPY
by: Promod Radhakrishnan

Ever since Q1 '10 calm was broken by the Greek crisis, markets have struggled to remain steady. VIX, VSTOXX and other volatility indices around the world are near 52-week highs and there is a very heavy sense of uncertainty across markets globally. The DJIA has already fallen close to 9% from the 10,500 levels in early January to 9600 levels as of today. Emerging market indices have also been as badly affected - the MSCI emerging market index for example is down over 8% YTD and the Shanghai index is down over 27%! It is perhaps safest to be in cash during this period of high volatility; but there might be an attractive risk-return play at current market levels.

It is important to understand macro trends at this point:

Budget tightening prompted by high deficits will cause restrained growth or a slowdown across Italy, Greece, Spain, U.K.. This would mean subdued growth in the near term for the Euro region as a whole. However, valuations across Europe are at one of the most attractive levels in the last decade [STOXX (P/E - 12.1), FTSE (P/E - 13.2), DAX (P/E - 14.5) etc], and hence there is little room for heavy downward correction in the short-term. Also, the quickness of response from Euro region countries during the Greek crisis earlier this year showed that there is enough governmental support to prevent any drastic fall out.

Property price pressures will continue to affect China. However, the correction in the market YTD have dragged valuations on the Shanghai index to less than 17 times reported earnings, compared with 37 times in July 2009. This is while economic growth is still expected to be 10.2 percent in 2010 and over 9 percent in 2011! Thus, there is not enough fundamental pressure to push stocks downward - and an upward correction in this quarter is highly likely. In fact, many investment banks including Morgan Stanley, BNP Paribas SA and Nomura Holdings have predicted that stocks will rally. Especially since China’s recent decision to end the yuan’s two-year 6.83/dollar peg to the dollar will help curb inflation and asset bubbles.

Other emerging markets
Most other emerging markets have dropped heavily YTD too, except India (BSE Sensex) which has stayed closed to neutral). Brazil’s Bovespa index dropped over 10 percent YTD and Russia’s Micex slipped over 8.5%. However, economic growth projections are still strong across most emerging markets, ranging from 3% in Russia to 9%+ in India. And it's important to note that most of these (except perhaps Russia) are cases where growth is driven by domestic demand and not necessarily deeply tied to global trade flows.

Job growth in the U.S. is still constrained with the unemployment rate projected to stay in the high 9% range until the end of 2010 and probably well in to 2011. Partly due to the same, the housing market will continue to face pressures (the recent bill to extend the date for the 8K rebate to September, notwithstanding).

However, projected economic growth across Asian and Latin American markets should continue to drive manufacturing exports. Banking balance sheets are much cleaner too (though regulatory pressures to add capital would continue): Banks are enjoying increased trading revenue due to high volatility, a gradual pick up in consumer and corporate credit and a moderate revival in the wealth management space. All these would help earnings. Retail stocks should also look up after the heavy sell off during last 2 months, which have left valuations at very attractive levels.

There clearly are enough factors to sustain market volatility: The risk of further sovereign downgrades in Europe, the potential for aggravated property price corrections in China, the speed of U.S. economic growth and job creation, sustainability of growth in other emerging markets etc. Any balanced investment strategy should hence favor heavier weightage towards cash. However, there are more valuation and macro economic factors pointing to a market reversal than a continued downturn. It is definitely not an easy call considering the continued volatility; but a thought-out risk-reward play should favor going long on emerging markets, but the U.S. Index bets are safer than individual stock bets due to aggravated volatility.

Disclosure: None