Stocks' Slow Summertime Burn: Safe Investments for the Months Ahead

by: Eric Parnell, CFA

It’s happening already. It’s only been two weeks since the end of QE2 and after only a few promising days at the start, it appears stocks have already rolled over to begin a descent lower. Not only does this deteriorating performance not come as a surprise, but it may also just be the beginning of a long slow summertime burn for stocks.

The stock drop off post-QE2 has come quickly. When QE1 ended on March 31, 2010, stocks managed to perform exceptionally well over the next few weeks. Stocks posted a +4% gain through April 26, 2010 that included gains in 14 of the first 17 trading days before rolling over.

This time around, post-QE2, the markets managed to muster a modest 2% gain over the first four trading days before reversing. Daily performance has been more evenly split so far, at 5 up days versus 5 down days. Much of the upside for stocks occurred on the very first day after QE2 ended on July 1. Clearly, it appears that any post-QE2 honeymoon period for stocks is not in the cards this time around.

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Stocks are not being soothed by the further expansion of the Fed’s balance sheet. One of the factors that seemingly helped drive stocks higher post-QE1 was the additional $32 billion in the Fed’s balance sheet during the first two weeks of April 2010. We’ve seen a similar pattern from the Fed post-QE2 which includes an additional $8 billion added to the balance sheet from July 7 to July 13. Perhaps this has provided some support to stocks and helped keep stocks from falling even lower in recent days.

Trends in the Treasury market suggest further downside for stocks in the weeks ahead. Treasuries continue to rally; the 10-year Treasury yield has shed another 11 basis points in the past week to close at 2.91%. It should be noted that most of this decrease in yield (and increase in price) came on Monday when fears about Italy boiled to the surface. It’s equally notable that the decline continued, albeit at a more measured pace, through the remainder of the week.

Overall, the move lower in Treasury yields post-QE2 is outpacing the post-QE1 period by a wide margin. This is occurring in the face of what is still an unresolved debt ceiling debate in Washington. All in all, the strong move lower in Treasury yields thus far is signaling that more pressure is likely for stocks going forward.

Looking ahead, the risks facing the stock market are meaningful:

  • First, the economy continues to decelerate and the threat of a double-dip recession is moving back on the table.
  • Second, the crisis in Europe is continuing to spread. Not only is the probability for a Greek default rising as we head toward August, but the heat is getting turned up in the other troubled markets including most notably Italy.
  • Third, despite some wavering in his words along the way, the likelihood of QE3 coming any time soon was diminished this past week by Fed Chairman Bernanke's Congressional testimony.
  • Lastly, additional uncertainty is lingering from the still contentious debt ceiling debate.

All of these factors and more are likely to keep stocks under pressure in the coming days and weeks.

As mentioned in my previous post on the topic, "Post QE2: An Eerily Familiar Pattern for Stocks", attractive opportunities exist for investors outside of stocks. These opportunities include:

  • Treasuries, with instruments like IEI, IEF, TLT
  • Gold, by trading GLD
  • Non-financial preferred stocks like ATT, ALM, FGE, DRU, XCJ
  • High quality defensive stocks from the food, household products and utilities sectors

Silver (NYSEARCA:SLV) is also once again looking interesting at the right price. (Click here for a list of my articles on these topics.)

This positioning proved favorable once again in the past week, although many areas should be watched very closely in the coming days depending on how things develop with Europe and the debt ceiling debate. Any unexpected shocks on either of these two fronts would warrant moving to cash on many of the positions listed above with the exception of Treasuries, non-financial preferred (in the case of a Europe shock) and gold (only in the case of a complete breakdown in the debt ceiling debate).

Stay tuned and keep your sunblock handy, as market turbulence could become scorching hot as we move through the end of July and into August.

Disclosure: I am long GLD, LQD, ALM, FGE, XCJ, DRU, IEI, IEF, TLT, LNT, WR, PG, CL, KMB, GIS, CPB, TAP, XLU. I sold CLX today following the takeover proposal announcement