Stock Outlook: The Final Straw That Breaks The Market's Back

by: Eric Parnell, CFA

It is only a matter of time. But the key question is not necessarily "when", but "what".

Stocks have been showing impressive resilience so far in 2012. After starting the year with a decisive break above the 200-day moving average on the S&P 500 Index (NYSEARCA:SPY), stocks have been drifting higher ever since. Stocks are now set up fairly neatly from a technical perspective as a result, as several downside support levels as well as upside resistance are all clearly defined. And stocks are far from overbought at current levels, even after the recent advance. These are certainly positive developments for a market that was thrashed about for most of the second half of 2011.

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Despite its recent strength, now is certainly not the time to become complacent about the stock market. On the contrary, it is becoming increasingly important to stand at the ready and take necessary evasive action when the time comes.

Policy Risk vs. Event Risk

A select set of risks has been driving the stock market since the early days of the financial crisis. As discussed in previous articles, the primary source of upside risk for the market over the last few years has been policy risk. The primary threat to those positioned to capitalize from the stock market going down at any given point in time is the risk that global central banks, including the U.S. Federal Reserve, will intervene with policy action that suddenly sends the market soaring higher. For those that are attempting to short the stock market, policy risk has been particularly treacherous over the last couple of years.

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In certain respects, policy risk has been even more detrimental to the stock market and the broader economy. This is due to the fact that a steadily rising stock market like we had during both QE1 and QE2 can lead to the perception that underlying problems are actually getting resolved when in fact they are continuing to fester under the mask of monetary stimulus. And just like with a disease, the longer it goes unaddressed in a patient, the worse the final resolution of the problem ultimately becomes. Such is the negative long-term consequences of policy risk.

On the flip side, the primary source of downside risk of today's market is event risk. On most days, we wake up to a market that is functioning normally (perhaps not rationally, but at least normally) and without any major shocks. But given all of the financial instabilities that continue to fester in the marketplace today, the primary concern among most investors and a key source of extreme stock market volatility in recent years is event risk. Such risk is the "Lehman Moment" that we hear so often referenced in the media today. In other words, it is the potential for that single day or weekend where something extraordinary occurs in the system that causes all hell to break loose in financial markets. Perhaps it is a hard default by a major sovereign such as Italy or Greece. Perhaps it is the failure of a major global financial institution. It remains to be seen exactly what event if any will join Lehman Brothers in infamous history of sparking the next crisis episode. But we still remain just one event away from another spiral downward in stocks.

The challenge associated with protecting against event risk is that it has become more nuanced due to the heavy influence of policy risk. One could run down a battery of events that have occurred over the last several years that had the potential to be "the event" that sparked the next crisis. Europe alone has provided scores of headlines through their chronic inability to stem the crisis that continues to deteriorate across the region. The effective default of Greece, the nationalization of Dexia and Italian 10-year bond yields soaring above 7% are just a few of many examples. But following each potential "event" moment, the stock market will at first recoil only to find its footing and resume its climb. Thus, it is worthwhile to dissect potential event risk even further to identify what is most likely to be "the event" that finally thrusts the market decisively to the downside.

Recognition Risk: The Key Wrinkle Behind Event Risk

The key event that will ultimately drive the market lower will come as a result of recognition risk, which can be considered a subset of event risk. Sure, a variety of events can occur that should sound the alarms and send the market lower, but if investors chose to ignore these events, the market will simply continue to drift higher or at least churn sideways. The question then becomes the following: what type of event must occur that will force the market into recognition of the problem and spark the ultimate decisive downside movement.

Looking Back on History For Lessons To Apply Today

A look back at the days following the Lehman failure in 2008 provides insight as to exactly where this recognition risk might reside. As we all remember, the collapse of Bear Stearns in March 2008 preceded the failure of Lehman Brothers in September 2008 by six months. The failure of Bear Stearns could have been considered "the event", but the market did not recoil much if at all at the time. Instead, it subsequently launched into a two month long rally through the middle of May. Were any underlying problems solved when Bear Stearns was gobbled up by J.P. Morgan Chase (NYSE:JPM) with help from the Federal government? Absolutely not. Instead, the market chose not to recognize the risks implied by the failure of Bear Stearns at the time.

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Let's fast-forward six months later to the failure of Lehman Brothers. Many media pundits and investors cite the collapse of Lehman Brothers as "the event" that caused the stock market to plunge into crisis. But a dissection of the days following Lehman's failure suggests that this is not necessarily the case. It may have been a catalyst that started the wheels in motion, but it was likely more the events that came after Lehman's collapse that shook the market into a staggering recognition of the problem that extended through March 2009.

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Stocks actually held up well in the days immediately following the Lehman collapse in mid September. Immediately after its bankruptcy, stocks were actually +0.27% higher over the next four trading days through September 19. And stocks were only down by -3% since the Lehman failure a two full trading weeks later on September 26. Thus, something else must have occurred besides Lehman to finally capture the market's recognition of the problem.

The fact that governments appeared no longer willing to step in and backstop financial institutions ultimately forced the market to recognize the problem at hand. Lehman was the first shot across the bow, but the market still clung to the notion that this might be a manageable, one off event. But in the days that followed, it became clear that different institutions would be handled differently and some would be left to die. While firms such as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) received the accommodation to immediately convert to commercial banks, others such as American International Group (NYSE:AIG) were taken under heavy government control. This raised the following uncertainty for many banks and their creditors - how much government support can we count on if any? And this question helped the crisis of confidence to brew further.

Washington Mutual was the second shoe to drop roughly two weeks later. On the evening of September 25, the FDIC seized Washington Mutual, which at the time represented by far the largest commercial bank failure with debt holders being wiped out in the process. What was particularly notable was that the government carried out this seizure without consultation with Washington Mutual senior management and the Board of Directors. The WaMu episode raised the stakes in the crisis of confidence. Not only might the government let a financial institution fail, but they also may not even consult with management in the process. And in the case of Citigroup's (NYSE:C) attempted takeover of Wachovia, the government may also decide intervene in rescue deals, pushing Wachovia away from Citigroup and into the arms of Wells Fargo (NYSE:WFC) instead.

How the TARP vote played out rattled confidence even more. When the vote for the government to provide assistance to failing financial institutions came to the House floor on September 29, it was presumed that the deal would pass. But instead, the vote was rejected amid a torrent of political rhetoric and scorn toward the financial institutions so desperately needing a rescue. Although a modified version of the bill was swiftly passed a few days later, the damage was done.

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These three events together ultimately shook markets into the following recognition. The government was willing to allow systemically important financial institutions to fail. They were also prepared to execute any seizures at a moment's notice and by stealth if necessary. And little sympathy was forthcoming from political leaders and the public. Mass liquidations quickly followed, as financial institutions scrambled to raise capital and trembled for months even after the government quickly returned just days later in early October with bend-over-backwards pleas that they would carry out no further punishment and would do whatever it takes to save at risk institutions. But confidence was lost when the market was forced into recognition of the problem, and it took six long months and extraordinary policy support from the government to begin to restore this confidence.

Applying the Lessons from the "Lehman Moment" to Today

What event would likely force the market into full recognition today? It all rests with the financial institutions. As long as the belief holds that global policy makers will not allow systemically important financial institutions to fail, will act with open communication and close coordination with these financial institutions, and will do whatever is necessary including political sacrifice to rescue these institutions, stocks will likely prove resilient. As long as these beliefs persist, financial institutions will likely not feel compelled to liquidate holdings in a frantic scramble to raise capital.

One Critical Difference

Today's circumstances have one key difference that will likely bring us to an ultimate day of recognition. And this key difference is bound to make the next crisis episode vastly worse than the Lehman moment if and when it arrives. The key premise that has enabled the market to brush past event risk to this point and avoid recognizing the true scale of the problem is the notion that global policy makers will do whatever is necessary to rescue systemically important financial institutions. But what if the size and scale of the problem grows to the point where global governments no longer have the capacity to rescue the banks? Worse yet, what if the governments relied upon to save these financial institutions from failure are teetering on the brink of insolvency themselves?

Such is the dilemma facing the market today. What stopped the bleeding six months after the outbreak of the financial crisis in late 2008 was aggressive policy intervention by the government. But if the government does not have the capacity to successfully intervene, then the system is going to fully cleanse itself whether policy makers like it or not. It is under this circumstance that a "Lehman moment" becomes a "Credit-Anstalt moment". And standing at the ready to react if and when the market is forced to fully recognize such an outcome will be critical as we move through 2012.

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How Best to Brace for a Stock Market Storm

Fortunately, the stock market is not the only game in town when it comes to investing. Instead, it is just one of many asset classes available to investors today. As a result, allocating to those categories where capital is likely to migrate during a crisis outbreak may prove not only prudent but also rewarding depending on how events unfold. Leading among these are safe haven categories such as Gold (NYSEARCA:GLD) and U.S. Treasuries (NYSEARCA:TLT). And one can even board up their stock allocations to a degree by including names that can still rise in the current environment and are also best suited to weather another crisis such as Family Dollar (NYSE:FDO), McDonald's (NYSE:MCD) and WGL Holdings (NYSE:WGL).

Investment markets, including stocks, continue to provide worthwhile investment opportunities as we move through 2012. But the risks bubbling under the surface continue to simmer. And recognition risk is rising as long as the situation continues to deteriorate in Europe, and the effects of this recognition risk may ultimately overwhelm any offsetting support from policy risk. This will be a key theme to monitor closely in the coming months. Stay closely tuned.

Disclosure: I am long GLD, TLT, FDO, WGL.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.