New Risk Aversion Could Test 2009 Lows

Includes: DIA, FXE, QQQ, SPY
by: Jorge Piedrahita

Equity markets are under pressure again, less than a week after Europe’s determination with a €750 billion package for peripheral countries created a massive rally of more than 4% on Monday.

While most pundits are almost exclusively focused on the Euro, I believe it is a mix of factors that are contributing to downward pressure on prices and market volatility.

The most significant headwinds are:

  • Increasing chatter regarding a potential break of the Euro (Paul Volcker) and doubts that Greece will be able to pay its debts (Deutsche Bank’s CEO Mr. Ackerman).
  • The implications of fiscal tightening on European economic activity assuming the plans are implemented. In addition, the political situation may turn volatile and populists may get elected.
  • The realization that stocks were priced to perfection under the assumption that we were in a classical post-war recovery which now looks less likely.
  • And lastly the widening of the Wall Street investigations and the financial reform which will lower return on equity for financial institutions and may derail the recovery via additional credit tightening.

The risk-reward trade off has changed in favor of caution. Retail investors have been questioning industry recommendation that equities are for the long run. Contrary to such recommendation, the Dow for instance is at the same level it was 12 years ago. Fixed income funds have been receiving large inflows as part of a trend that I believe is a secular one.

At a macro level, the concern is that the so-called recovery is fragile with several trouble spots -- Europe, China and the U.S. The inventory cycle is ending and the second half of 2010 will see a significant deterioration with the potential to be in a recession again by the end of the year (I may argue we never really started a sustainable recovery).

We probably have started a risk aversion process that could test the 2009 lows during the next three to six months. Investors should focus on capital preservation with conservative fixed income portfolios.

Disclosure: Short equities

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