Storm Clouds Building On The Stock Market Horizon

by: Eric Parnell, CFA

The date was September 21, 1938. The location was the northeast United States including Long Island and New England. And lives were forever changed by a hurricane that arrived unexpectedly, caused catastrophic damage and to this day ranks among the most severe weather events in history. While we are well beyond hurricane season as we drift toward the beginning of March, investment markets certainly are not. Instead, unsettling storm patterns are now building on the stock market horizon. And the resulting damage has the potential to be the worst the markets have seen in a lifetime.

"The day dawned very nicely. There was sun."

While the area had been saturated from steady rains in recent days, there were no signs of the impending danger threatening the northeast U.S. on the morning of September 21, 1938. And such is the current state of the stock market. A look at the charts suggests there is nothing at all to worry about in the current environment. Stocks have been riding high since the first day of 2012. They have risen in 25 out of the first 36 trading days on the S&P 500 Index (NYSEARCA:SPY), which is a near 70% daily win rate that is +4 standard deviations above the historical average. Stocks are also boldly pressing to break out to new post crisis highs even with a Relative Strength Index that remains steadily at or above overbought readings and momentum indicators already at prior peak levels. It certainly has been a sunny start to the New Year for stocks to say the least.

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"For days, this hurricane had been carefully tracked by the Weather Bureau in Washington, but with no sense of alarm. Its weathermen believed that hurricanes never hit New England. This storm, they were sure, would veer safely out to sea."

Despite prior knowledge of the threatening storm, it was dismissed as nothing to worry about. A similar threat is now building for the stock market. Just as it drifts to new highs seemingly every day, the situation in Europe continues to deteriorate. Most notably, Greece is now descending toward what will potentially be a default event in the coming month. And how this event plays out has potential repercussions not only for the Euro Zone but also for the global economy.

"By 2 P.M., barometer readings were falling all along the coast. Winds climbed to 45 miles an hour, but there was still no official warning of the hurricane, now just two hours away, so people held to their plans."

Although the weather was becoming severe that day, the lack of an official hurricane warning caused many to stay the normal course of their day. And although a default event in Greece appears to be drawing very near today, many in the market simply assume that either European leaders will "find the political will" to resolve the situation in the end or that such an event is already "priced in" to the markets. First, "finding the political will" has in certain respects become another way for an analyst to say "although I don't know exactly how, I think everything is going to work out, so I'm not going to worry about it". Such thinking leaves a bit to be desired. Also, how can a market "price in" an outcome when it still knows so little about the details of how events will play out? More directly, if policy makers directly involved in the ongoing negotiations are still struggling to grasp how events will be resolved in the coming days, the market certainly has even less knowledge of what to expect at this stage. Whatever happens in Greece or across Europe, it is certainly not "priced in" by any means.

"The ocean turned a sickly yellow color. The wind yanked trees with all of their roots out of the ground and churned the leaves into a paste."

Just like the Great Hurricane of 1938, the immediate market reaction is likely to initially be severe once the official Greek default event finally occurs. But just like the storm that day, the actual path of this market reaction may not actually be what most market participants are anticipating.

"Then, suddenly, the wind died, the sun broke through and people emerged to assess the storm's toll."

When the hurricane first made landfall that fateful day in 1938, the initial impact was dramatic. But the storm suddenly broke and people thought the worst was over. We can reasonably expect a similar reaction play out during any default scenario coming out of Greece.

When reflecting on the "Lehman moment" of 2008, one of the most overlooked facts was exactly how the market reacted in the aftermath. Over three years later, many analysts and media commentators recall the fact the market immediately cascaded lower after Lehman failed. This was not at all the way things played out.

After the initial reaction to the Lehman bankruptcy announcement, which was a -5% sell off on the S&P 500 on September 15, 2008, the stock market actually stabilized and the skies cleared. Nearly two weeks later on September 26, the stock market was actually UP nearly +2%. It was only after this point that the market storm truly picked up steam and the cascade lower began.

Thus, if Greece were to officially default in one form or another, it would not be surprising at all to see a fairly muted initial reaction from the stock market. Any immediate sell off could be conceivably followed by a market that holds steady and even rises over the next few weeks. Such a reaction would likely be due to the fact that the financial system has been preparing for such an event for some time through programs such as the European Central Bank's LTRO program and the globally coordinated liquidity program that was put into place back in November.

"People all over the area thought the storm was over and came out. Then, of course, the wind shifted from the northeast -- which it had been blowing -- and to the southwest, and the eye passed over and then it began to blow twice as hard as it had before."

When the storm broke and the skies cleared, those affected by the hurricane of 1938 mistakenly thought that the storm had passed. Of course, the worst was yet to come. And in regards to today's stock market, the true risk does not necessarily lie in the immediate aftermath of a Greek default event, for this is the event which policy makers are prepared. Instead, the real danger lurks in the weeks that follow. And this is something that may ultimately surprise many market participants if they happen to wade back into the stock market in the aftermath of a Greek default under the belief that the worst has passed.

Historically, the reason for the delayed stock market reaction is that the real contagion effects ultimately end up coming from sources both unanticipated and unforeseen by policy makers and investors. It took over two weeks after the collapse of Lehman in 2008 before stocks cascaded lower. And it took well over a month following the collapse of Credit Anstalt back in 1931 before the massive slide in stocks got fully underway. In both cases, the reason for the delay was that the forces that eventually unwound the stock market in the end came from elements that were well removed from what was perceived by policy makers as the primary focus of concern following these catalyst events.

When looking at the size and complexity of the problem confronting European policy makers today not only in Greece but also in Portugal, Ireland, Spain, Italy and other at risk sovereigns across the region, it is more than reasonable to expect a similar delayed reaction from the markets once again this time around. Thus, if Greece were to default, the stock market may at first appear fine before plunging into darkness several weeks later once the actual fallout effects of the event start bubbling to the surface.

Financial storm clouds are building on the horizon. And the stock market is worryingly complacent about the tempest that may soon be unleashed by any default event from Greece. Thus, now is the time to begin preparations for your portfolio, as any advanced warnings from the media or analysts cannot be relied upon as sufficient protection. And with the stock market still trading at previous highs from a year ago, the time may be particularly right to adjust portfolios as needed.

A variety of asset classes can be expected to provide adequate shelter from any market storm. Leading among these is Long-Term U.S. Treasuries (NYSEARCA:TLT) and Long-Term U.S. Treasury STRIPS (NYSEARCA:EDV). Both provide an attractive way to capture upside in crisis markets while also hedging existing stock exposures. Other categories that should also provide portfolio protection are U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP), Agency Mortgage Backed Securities (NYSEARCA:MBB) and Utilities Preferred Stocks.

Although likely to sustain some of the market winds in a crisis event, precious metals such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) are also attractive ports in a storm. They would likely rally initially on any default news, but then may come under some pressure due to mass liquidation activity by global financial institutions. But such liquidations have historically proven outstanding buying opportunities, particularly if global central banks were to aggressively intervene with even more monetary support in an attempt to clean up the damage after the storm.

With all of this in mind, it is still possible that the ominous storm on the horizon may pass along and never make landfall on financial markets. Perhaps policy makers will be able to steer the Greek situation toward an orderly resolution in the end. Or perhaps policy makers will cave once again and postpone dealing with the Greek situation for another day. It is for this reason that it remains worthwhile to maintain stock exposures even with the market trading at previous highs. With this being said, focusing allocations to the more defensive areas of the market has merit not only for the lower volatility associated with these names but also for the fact that these same names have vastly underperformed the broader market so far in 2012. Representative names that have shown the repeated ability to not only hold up but even push higher in the face of crisis include McDonald's (NYSE:MCD), Family Dollar (NYSE:FDO) and Bristol Myers Squibb (NYSE:BMY). Even Wal-Mart (NYSE:WMT) might be worth a look following its recent precipitous sell off.

The storm clouds continue to build on the stock market horizon. And in the event the rains begin to fall and the winds start to whip up, take good care to find shelter from the storm before the real damage is done to your portfolio.

Disclosure: I am long MCD, FDO, BMY, GLD, SLV, TLT, EDV, MBB, TIP.

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.