Self-Fulfilling Recession Worries Fueled by Fear: How to Play It

Includes: AGG, DIA, GLD, QQQ, SPY
by: Kurtis Hemmerling

The 6.7% drop in the S&P 500 was one of the most insane price moves I have seen in some time. The small jump Tuesday morning is nice, but who knows how long it will last. This truly underscores the difficulty in making investment decisions based on fundamental and rational economic data. I decided it is time to throw my tattered hat into the ring for yet another viewpoint on how to play this volatile scenario out.

A Rational Market Move?

Did the market deserve the massive price drop? Some say the market prices in all available information and it is always correct. While this ideal sounds great, the market more likely prices in sentiment and not the actual news. If all investors watched the new Smurfs movie and loved it, this could help the market rise - although totally unrelated to equity markets and general economics. The point of the hyperbole? The tug-of-war between fear and confidence move our economy and this is fueled by the plethora of news - with varying degrees of actual relevance.

Back to the market drop ... yes, the USA got a small downgrade. Fear put aside, how much would this downgrade really affect the equity market? Would it lower future earnings by 25% until the rating was lifted to AAA? Not a chance! But the fear factor of this rating downgrade, despite being only weakly correlated to equity markets, is really what creates a self-fulfilling prophecy that may very well throw us back into another recession. The problem is not necessarily the news - but how it is received.

The Self-Fulfilling Prophecy Cycle

So how is information overload exacerbating the problem? It is true that governments need to work harder to balance the budget if the economy is to be less volatile and more sustainable. Widespread dissemination of this knowledge rightfully frightens people. Is their money safe? Even if governments back up your savings in the banks - how safe is it really when the governments can't pay their own bills? Fear that the banks won't have enough liquidity will actually create liquidity problems. It is self-fulfilling since only a small percentage of the banks' assets worth are held in cash. Lack of liquidity creates credit problems for businesses and consumers. This in turn leads to less spending which turns into reduced earnings. If earnings go low enough for too long, a recession is announced and the problem deepens. In turn this will drive down fundamentals on stocks which many will point to as proof that their initial worries were valid. We are now back to the government needing to spend money with stimulus packages - which they can't afford if they are to stay on a sustainable budget. The loop goes round and round and information-fed fear is what adds fuel to make a hypochondriac's economic nightmare come true.

On the verge of getting totally off topic, don't the public deserve to know the truth? Yes, but if they continue to react irrationally to the truth, or misinterpret it for a harmful outcome, we have a fear-driven economy that threatens to destroy the ideals of the equity market based on fundamentals. Or we have a highly manipulative market where if you cry wolf loud enough - one will hear and come to do your bidding.

Yet Another Economic Forecast ... Sigh

But I digress, my play for the market? I see a downside for the dollar. The ratings downgrade has created fear of the U.S. dollar. There could be foreign unloading, or a lack of future buying interest. If QE3 is announced, more inflationary pressure on the dollar will come into play. This will make the price of gold appear even higher when quoted in U.S. dollars. Sovereign debt woes will create more buying of gold as a safe-haven. As gold goes up, more ETF and related products become available for the average person to get their hands on the yellow metal. Gold has been globalized, or more correctly individualized, so that virtually any single person in the world can easily buy the metal. This too adds to the volatility.

As confidence in gold rises compared to fiat currency, another self-fulfilling prophecy of higher gold prices occurs. I'm waiting to see the parabolic move that will take gold up to $2,500 or $3,000. I'd only place small highly-leveraged bets that this would happen, but so far it has been right on the money.

However, the downside is scary to contemplate. The World Gold Council reports on what percentage gold makes up of foreign reserves around the world. In July, the USA had 8,133.5 tonnes to make up 74.7% of the reserve in gold. Germany had 3,401 tonnes to make up 71.7% of their reserves. China won't be as affected since although they have 1,054.1 tonnes, this only makes up 1.6% of their reserves. If gold goes parabolic and drops - then governments have the difficult task of either dumping tonnes to preserve their worthwhile compounding the drop, or having a piggy bank that vaporizes like a drop of water on a hot frying pan. Either decision leads to a negative outcome.

Market Ready For Buying?

What about the equity market? Based on the earnings yield of the S&P 500 versus the 10 year Treasury yield, I'd say the market is a good buy. The risk premium - or difference between the two - is at 6.39%, which insinuates the same value offered when the S&P 500 sat around 700 in 2009. But as long as fear reigns - I believe that a recession is a grave possibility - and in my books it is a probability. As credit tightens and spending drops, the lowered earnings forecasts and negative surprise earnings will throw more negative information fuel on the fire for the panic-filled public to digest. If the government is willing to toy with another ratings downgrade from S&P, the stimulus and quantitative easing may only push the dollar lower and the price of gold higher.

When you are balancing a fear of a recession which will crash equity markets with the stimulus you can't afford or even pass and a ratings drop you desperately want to avoid with the threat of an ever decreasing value on the dollar - there is always a negative news story around the corner that could turn into a 'algorithmic high-frequency trader' dream of roller-coaster volatility.

The Short-Term Play

For now I think it prudent to stay on the sides and see how things play out or make a few speculative trades on gold. When you see a market rally last more than a week with one specific day of abnormally high volume where the prices jump 2-4% or more, then I'd recommend cautious buying while putting your stops in at the previous market low of the last week or two.

These are tough waters to navigate when fear is king and sentiment weighs in far more heavily than rationality and fundamentals. I fully expect the market to jump on certain items such as FED announcements of more easing and the like, but these will only be sustainable boosts if confidence can be restored - a quality in short-supply. Sadly, unless things change, the equity markets are turning from an investment platform into a traders video-game.

Keep in mind - my nickname is Chicken Little - so take this article for what it is ... a hawkish view to take with a grain of salt to weigh out the other articles which say to back up the truck and buy on any little dip.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.