Investing in the 'Shock' Market

by: Efficient Alpha
Bloomberg reported Monday that stocks are at their lowest valuation in 26 years as housing, unemployment and Greece threaten to drag the economy back into the red.
Losses since April have pushed the price of the S&P 500 (NYSEARCA:SPY) to 14.5 times the past year’s earnings, compared with the average of 20.5 since June 1991, according to Bloomberg data. The gauge is valued at 8.7 times cash flow, cheaper than in 81 percent of occasions since 1998. The gauge is priced at 2.1 times book value, or assets minus liabilities, lower than it has traded 90 percent of the time since 1995.
Clearly some of the wind has come out of the bull market’s sails, but is this the pause that refreshes or a premonition of things to come? May’s unemployment numbers spooked the market even as most agreed that the numbers would be temporarily low due to Japan and higher commodity prices. The June statement released by the Federal Reserve today points to the slower pace of recovery as ‘likely to be temporary’ and contends that the recovery is ‘continuing at a moderate pace.’ I would agree with this and count myself in the bullish camp given valuations. The labor market has begun to rebound somewhat and the housing market appears to have stopped its massive hemorrhaging, for now.
That said, as any value investor will sadly confirm, things can always get cheaper. The market is not without its worries. Though longer-term valuations may appear promising, there are several foreseeable events that could cause some considerable heartburn for the anxious investor. How can the optimist profit by being first to the market’s party without paying the price if the host turns belligerent?
It’s All Greek to Me
Alan Greenspan recently told Charlie Rose that a default by Greece is ‘almost certain’ and that the event risks pushing the U.S. into another recession. Although Prime Minister Papandreou has won his confidence vote in parliament, he still has to win over the public with austerity measures. Markets will likely be on edge all the way up to next Tuesday’s vote on the austerity package, but on the off-chance that Greece manages to restructure its debt and avoid a default, we still have considerable debt worries from the rest of peripheral Europe. The Euro will most definitely be affected throughout the rest of the year, gaining as news gets better and sliding as things get worse. Short of opening a Forex account, the ProShares Ultrashort Euro (NYSEARCA:EUO) fund can help investors hedge their portfolio against problems across the Atlantic. As largely a financial crisis, one could also look to the banks for a hedging position. Arguably all banks will feel the pain from a default, but some more than others. The SPDR S&P International Finance (NYSEARCA:IPF) has a 55% weighting in banks, 50% of which is exposed to Europe. The iShares S&P Financials Index (NASDAQ:EUFN) holds a 56% exposure to European banks. Compare this with State Street’s Financial Select SPDR (NYSEARCA:XLF) with a 97% exposure to U.S. banks and one gets an idea of possible long-short positions.
Gaming the Fed
The consensus is, and forever will be, divided on the effectiveness of QE2. The simple fact is that it will come to an end on June 30, and this could have some significant effects on commodities, the economy, and your portfolio. The Fed rarely moves from easing straight to tightening, so the overall size of the balance sheet will probably not change much through most of this year. The bank will most likely reinvest assets as securities mature or, at most, allow the balance sheet to decrease slightly by reverse repurchase agreements. Whether the lack of stimulus causes the U.S. to double-dip or effects the economy in a more muted way, liquidity will be coming out of the markets. This should have the most pronounced effects on commodities and those economies which have profited most from easy money policies.
Gold has some seasonality price pressures coming in July/August, which makes it an ideal short against decreased liquidity. SPDR Gold Trust (NYSEARCA:GLD) and ProShares Ultra Gold (NYSEARCA:UGL) are two options popular with investors. Oil may also feel some pressure from decreasing liquidity, but could also slide if the economy falters or we see some stability in Libya. Futures and options in crude are available from the CME Group (NYSE:WTI). One way to play it may be to sell short-dated futures or options and buy those further out. This position will profit from a stronger economy in the second half, but hedge against temporary weakness in energy.
Investors must perform their own due diligence and understand how a position or event will effect their existing portfolio. For example, any default event in Europe will most certainly drive investors to safe assets and drive up the price of gold. You could be patting yourself on the back over your short-Europe trade while cutting losses on your short-gold trade.
Stay tuned. I’ll cover a few more possible game changers in a future article. Until then, feel free to suggest events you would like to hedge against.

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