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FiatFxWorld considers global themes when making medium and long-term investment decisions. His background is in Emerging Markets and he uses quantitative and analytical methods extensively to support his work. He lives and works in Singapore.
  • Market Timing: Why You Should Go (Very) Defensive Now

    This year has no doubt been an interesting time for market observers and investors. Year-to-date performance is unexciting, although in many asset classes positive - Credit is the star performer (and fixed income generally), US equities at around 8% are respectable, Emerging Market equities are a little above zero, while European equities underperformed - especially in USD terms. Yet these numbers do not tell the whole story, as there have been at least two distinct market phases - first half of the year fueled by LTROs and growth hopes followed by disappointing developments in Europe and a correction in May. This correction has been followed by a pretty strong bounce since early June, which brings us to levels, which provide a great opportunity to reduce risk or to go outright short.

    Downturn signals

    The economic cycle has been clearly weakening since January. We started the year with many investment bank PhD's calling for 2.5-3% growth in the US in 2012. Today we are looking at growth around 1% in Q2, with little hope for improvement in the 2nd half of the year.

    An estimate for OECD countries (essentially the developed nations) published by SWIFT based on international bank payments is confirming the slowdown in the coming months:

    (click to enlarge)SWIFT OECD growth estimatesWeakening growth momentum is confirmed by leading indicators, such as the PMI indices. The most leading data series for the US economy - ISM New Orders - is suggesting we may be heading for a downturn of the more serious variety. It has correctly "predicted" the '01 and '07 downturns.

    (click to enlarge)ISM New Orders vs S&P500Weakening growth momentum is by no means confined to the US. Emerging Markets are similarly in a broad based slowdown - whether we consider Taiwan, which makes a living from exporting computer chips, or Brazil who's in the commodity business.

    (click to enlarge)Taiwan and BrazilStocks and Sectors

    Stock-level developments are of course not isolated from the Macro growth slowdown. Given operational and financial leverage, earnings react strongly to swings in the top line. Sell-side analysts are already downgrading earnings forecasts - downgrades are outpacing upgrades by a large margin.

    (click to enlarge)Earnings Revisions

    Cyclical sectors such as Materials and Industrials have already underperformed, and reflect - at least partly - these reduced growth expectations. I am afraid this is not the case for many other sectors and assets though.

    (click to enlarge)cyclicals/defensivesThe Price of Risk

    Surprisingly, we are going into this slowdown with very little risk priced into assets. This shows in low levels of implied volatility as well as low credit spreads. (actually FX volatility is at the lowest level since 2007)

    (click to enlarge)volatility vs creditThis low level of volatility and credit spreads has two implications. Firstly it shows markets expect calm ahead. Secondly, it is cheap to purchase protection in the form of options. It also means that when risk reprices and volatility goes up, prices will fall, and the scope for that - simply from risk repricing - is quite significant.

    Tail Risks

    Finally, the discussion about the market outlook, and asset allocation, would not be complete if we didn't mention a few significant tail risks.

    A lot has been written about the European Crisis, however that doesn't mean the situation has gotten any better. In fact, the outlook is hopeless. Let me draw your attention to only one chart, which shows the degree of devaluations of the different European currencies vs the Deutschmark before the countries went into a fixed-exchange regime (the Euro). France devalued ~60%, Italy ~80% in the 25 years pre-EMU. These devaluations reflect the differing structures of economies in Europe, which in all likelihood have persisted. Of course there has been no devaluations in the 14 years since 1998. The pressure for break-up will not go away anytime soon. On this point, the Spanish government 10-year and 5-year bonds have fallen to record lows (yields at record highs) on Friday.

    (click to enlarge)EUR FX pre-EMU

    Other tail risks include a further slowdown in China (it already went beyond expectations from only a few months ago) and the US fiscal cliff (politics really appear dysfunctional in the biggest economy).

    Conclusion and Recommendations

    The opportunity to position for downside is excellent right now. Growth is clearly slowing, cyclical indicators are turning lower yet volatility is cheap and share indices quite high. Growth is getting downgraded and negative earnings revisions are large. Europe and China are additional tail risks.

    Focus on capital preservation. Cash may be better than the Investment Grade Credit ETF yielding 3.5%, High Yield or indeed the stock market. I am not a perma-bear and have played the market from both sides (ie. here), however now the risks outweigh the potential rewards by a large margin.

    Why are we not lower already? It is not clear, however central banks may have something to do with it. Can the Central Banks save us? It's doubtful, and even if, then this is not the right entry point to bet on it. The late stages of a bull run (2009-2012?) are generally tricky. Is the bad news already discounted? Maybe by the treasury market, but not the stock market. Now is the time to take downside exposure - especially via options, which are trying to tell us "don't worry, all will be fine". I doubt it.

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

    Jul 24 11:26 AM | Link | Comment!
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