As readers know, starting on October 27th of 2011, I wrote a series of articles in which I predicted that global stock markets would top out by late April of 2012 and that the subsequent decline would take the S&P 500 to the area between 950 and 1020 on the S&P 500.
Evaluation My Investment Thesis Thus Far
To this point, events have essentially transpired as I have foreseen.
First, global markets appear to have topped out in March and April of 2012, with the most economically sensitive sectors and the key hot-spot regions leading the way.
Most importantly, my substantive thesis regarding the drivers of the global equity decline could hardly have been proven more accurate. My main thesis has been that the economies of the PIIGS would enter into a "death spiral" characterized by rapidly contracting economic activity, exacerbated by fiscal austerity measures, which in turn would produce even wider (and frighteningly unsustainable) fiscal deficits. I argued that serial and severe violations by PIIGS of fiscal deficit targets enshrined in various treaties would set off a Euro-wide political crisis in which Germany and a few of its northern European allies would be unwilling compromise quickly and/or decisively enough to avert a full blown economic and fiscal crisis in Southern Europe that, in turn, would ultimately drag down the entire EU economy. In this regard, I highlighted the situation Spain as the detonator for the region-wide crisis.
In my various articles I have pointed out several temporal catalysts for the ultimate detonation of the end game: Greek elections, French elections, and the global realization that Spain's economy was in a downward spiral causing it to badly violate its recently agreed to fiscal targets.
In sum, my description of future events could hardly have been more accurate to this point.
The next Euro summit on June 28 and 29th is being widely perceived as perhaps the last chance for Europe to avoid the sort of full-scale crisis that I have envisioned.
In my view, at this point, the hope that a full-scale European crisis can be averted is merely wishful thinking, bordering on naiveté.
At this point in time, the downward spiral in Spain and Italy's economic and fiscal situation is absolutely uncontainable. There are no realistically possible policy measures that can avert severe economic contractions in Spain and Italy and the simultaneous massive ballooning of their fiscal deficits. Whatever is done on June 28 or 29th, it is already too late to avert massive recessions and massive fiscal deficits in Spain and Italy.
In theory, an ECB backed guarantee of unlimited funding (directly and/or via the ESM/EFSF) for the Italian and Spanish sovereigns (which would enable financing of huge projected deficits) could calm financial markets for a few weeks. The immediate approval debt mutualization via Eurobonds (or some other similar vehicle) could also conjure up market hopes of a positive resolution. But alas, neither of those potential "solutions" are going to be implemented any time soon, as the Germans have made abundantly clear.
During the course of the past few weeks, the German government and the Bundesbank have very carefully, meticulously and painstakingly articulated a very clear and coherent rejection of global demands that they support debt mutualization either through Eurobond issuance or via ECB sovereign bond purchases. You can agree or disagree with the German position. But the fact is that the Germans could not possibly be clearer about what their position is and will be.
Interestingly, the market as a whole has adopted a posture of willful disbelief regarding the German position and its consequences. The overwhelming market consensus has been and still is that the Germans and/or ECB will do whatever it takes to avert a Europe-wide crisis. This earnest faith is very soon to be exploded as it will become clear after June 28-29 that the Germans are not willing to do enough and/or fast enough to avert a horrific economic and fiscal crisis in Southern Europe. And this, in turn, means that a full-fledged Europe-wide economic and fiscal crisis is inevitable.
And this, in turn, means that a global economic and financial crisis is now essentially inevitable.
How The Global Crisis Will Unfold
The first major focal point for the coming global crisis, outside Europe, will be China. Data now indicate that the Chinese economy is headed for a hard landing. In the past, one could count on the Chinese implementing massive fiscal and especially monetary stimulus to offset the external shock to its critically important export-linked sectors. And make no mistake: The Chinese government will take substantial measures to avert a depression-type scenario via expansionary fiscal policy and accommodative monetary policy. The only question regards the extent and/or effectiveness of these Chinese counter-measures.
The problem in China is that the effectiveness of monetary policy will be severely constrained. The massive investment bubble (concentrated in export industries and the real estate sector) propitiated in the past few years means that the credit demand that might otherwise have been mobilized by accommodative monetary policy is simply not there.
Chinese officials have been strongly cautioning that their ability to rescue the Chinese economy from global shocks is quite limited this time around. These officials know of what they speak. Interestingly, the consensus around the world implies a willful disregard of what Chinese officials are warning about. The consensus is essentially assuming that the Chinese are just "kidding" and that they will ultimately do whatever is necessary to preserve 9%-10% annual GDP growth. This consensus will be exploded in 2012 and 2013.
The coming sharp slowdown in China will reverberate throughout Asia and will cause sharp recessions. Global commodity prices will be devastated. Commodity-dependent countries in the Middle East and Latin America -- as well as Canada and Australia will experience sharp economic contractions.
The US economy will be one of the last major economies of the world to be buffeted. It will also be one of the ones that will be least affected, given the relatively autarkic nature of the US economy. The US economy is overwhelmingly driven by internal forces and does not essentially depend on global trade.
Buffeted by contagion through financial channels and by soaring risk aversion amongst businesses and consumers, the US economy will slow sharply and could very well experience a mild recession. Indeed, I expect the next few quarters will be characterized by a sharp economic deceleration and a rise of economic fear America. However, my base-case expectation is that the US can ultimately avert the worst of the global economic and financial crisis.
S&P 500 Impact
S&P 500 earnings - and ultimately the S&P 500 index -- will be far more impacted by the global economic and financial crisis than the US economy will be. Unlike the US economy, the S&P 500 is largely driven by international forces. Well over 40% of S&P 500 earnings are generated outside of the US - with Europe alone responsible for upwards of 15% of all S&P 500 profits.
Year-over-year (YoY) earnings per share projections for S&P 500 second quarter 2012 earnings have been coming down steadily for several months and this trend has recently accelerated with a series of major downwards earnings revisions. Nonetheless, consensus still projects 2Q 2012 earnings to grow about +3% relative to 2Q 2011. By contrast, I (and various other analysts) expect 2Q 2012 earnings to post negative YoY earnings growth.
More importantly, consensus is currently expecting double digit YoY earnings growth from 4Q 2012 through 2Q 2013 - a fact which merely highlights how completely delusional consensus currently is. 12-month forward consensus operating EPS for the S&P 500 is currently projected at around $111. By contrast, I expect a figure in the low 90s -- a far reasonable expectation given the current global economic outlook -- which implies a high single digit decline in EPS.
The biggest earnings declines will be in energy and basic materials sectors that will be devastated by the collapse in commodities prices. Technology, which is by far the S&P sector with the largest percentage of non-US exposure (around 60%) will be one of the most hard-hit sectors. Furthermore, much of the massive earnings growth currently projected in the financial sector (50%+) will not materialize, and this will exert a major negative impact on overall S&P 500 EPS.
The die has been cast in Europe and globally. A global economic and financial crisis is now virtually inevitable and the S&P 500 index will likely drop to the 950-1020 region before any sort of credible reflation measures by global central banks can be brought to bear.
While I do not recommend shorting for average investors, I have personally been scaling into short positions for the past few days. Investors interested in exploring options to capitalize on the coming decline in US and global markets can look at shorting SPY, DIA, XLB, XLY, XRT and going long VXX. There is significant upside risk through the June 28-29th EU summit so the optimal timing on shorts will be tricky. However, my plan is to continue to scale into short equity positions and long volatility positions and to pounce heavily once it is clear that the June 28-29 summit will not avert a full-blown crisis in Europe.