Economic Pressures, Barriers To Shocks And Sensitive Financial Markets

Includes: DOG, DXD, EEM, EWG
by: Erik Dellith

"All my nerves are naked wires, tender to the touch, sometimes super sensitive, but who can care too much?" If you're looking for a song that clearly captures the current mindset of traders and investors, turn an ear to "Scars" by Rush. Just look at how the market has reacted to bad news, from the European debt crisis to Friday's labor figures.

(I am in no way speaking for any member of the band; I just like the song.)

This is not to say that the market has over-reacted, but simply that people are acutely aware of any bit of bad news, and understandably so given the still-aching wounds inflicted by the Great Recession. "Scars of pleasure, scars of pain, atmospheric changes, make then sensitive again."

Further, the latest economic statistics suggest that we have sufficient reason to be concerned. Generally, if things were going relatively well, the U.S. economy could pretty much weather soft economic conditions in Europe. But that isn't now. With Spain and Greece in deeper-than-forecast recessions, and the potential for significant spillover through the rest of Europe, it seems like there is a pretty big economic tidal wave crossing the Atlantic and about to land on our shores. We've already had some early ripples, but the larger wave is likely still on its way.

If our economy was humming along, we would have the equivalent of large barriers to break the approaching wave. Unfortunately, that is not the case. The downward revision in GDP growth earlier this week was bad enough, because it suggests that momentum is weaker than previously anticipated.

It would be easy enough to point out that the consumer still fared well in the first quarter, with personal consumption expenditures rising for the third consecutive quarter; that reassurance quickly fades with the latest jobs report. The year started off on a relatively solid note, with 275,000 jobs added in January. That number isn't great, but it gave some hope. But that hope has faded, as job creation has fallen each month since then, bringing us to May's number of 69,000 new jobs.

This suggests that the barriers against the approaching tidal wave are not nearly as large or as strong as we thought they were just a few months ago. That does not bode well, particularly with conditions deteriorating in Europe (consider the rising cost to insure against a Spanish default) and growth slowing in Asia.

PIMCO's Bill Gross recently suggested investors steer clear of Europe. I'm in no position to disagree. Investors will likely have difficulty finding refuge from the European crisis anywhere in the continent (not impossible, just difficult). Consider Germany, the economic powerhouse of the region, for a moment. Over the last three months, the iShares MSCI Germany Index (NYSEARCA:EWG) has fallen slightly more than 15%. By comparison, the S&P 500 Index is down just about 5%. Over the last year, EWG has shed about 25% of its value, while the S&P 500 is essentially flat. Given this performance, one might find it difficult to present a reasonable plan explaining the benefits of exposure to this region.

Unfortunately, as the saying goes, during periods of crises all correlations go to one. Emerging markets have not been immune from investor disinterest in risk, as we've seen in recent fund flows. The iShares MSCI Emerging Markets Index (NYSEARCA:EEM) is off about 15% over the last three months, and 20% over the last year.

What does this mean for going forward?

The U.S. economy continues on a slow-growth path. Absent external influences for a moment, I do not see any catalyst for growth on the horizon. Quite the opposite. Absent a significant resolution to the "fiscal cliff" and tax situation at the end of the year, we would likely see some considerable slowing in 2013. Given the current trend of sluggish growth, a recession is almost guaranteed. I am hopeful that politicians will heed the warnings of people like the Federal Reserve Bank of New York's William Dudley and arrive at some solution. Of course, it is an election year.

What about that tidal wave?

I would still like to remain somewhat optimistic that the powers-that-be will arrive at some lousy solution for Greece. (A good solution is nearly impossible.) As Economic and Monetary Commissioner Olli Rehn reportedly stated in a Bloomberg article: "It's important to face the truth … We must continue measures to balance public finances at the same time as we need structural reforms and actions that boost growth."

At the same time, one cannot ignore the obvious concern that things will likely get worse in the near term before they get much better. Any stock market exposure needs to be carefully hedged against the broader downtrend.

The ProShares Short Dow 30 (NYSE:DOG) seems like a reasonable approach to capitalize on further deterioration in the markets. Still, it might be worth picking up the ProShares UltraShort Down 30 (NYSE:DXD) if you're a bit more pessimistic than me.

Of course, given that traders' nerves are naked wires, tender to the touch and super sensitive, news of any potential resolution to the European crisis could ignite a rally. And such a turn-around could be particularly difficult to time and exceptionally damaging to downside bets.

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