2012 Market Breakdown

The past year was characterized by paranormal volatility, especially in Q4, which has since subsided. No longer have we seen swings of several hundred points in the Dow on a daily basis as NYSE volume has fallen as well. Domestic equities have rallied YTD, led by financials and tech, which were the main laggards in 2011. It seems large institutional investors (retail cash remains predominantly on the sidelines) have become numb to the constant, yet ultimately inconsequential, noise from the Euro Zone. Whether the market is now overbought becomes a fair question to entertain. Fears of economic deceleration have subsided (sans Europe) for the most part, barring that China doesn’t experience a hard landing and raising rates helps stabilize their overheated economy. Many people have come to view Japan’s debt burden as a significant threat to the global economy as well, particularly on the backdrop of years of miniscule output. In terms of fundamental support for the domestic rally, however, one can point to the strength of the manufacturing industry, which has improved, as has retail, in the month of January. In the employment arena, 243,000 jobs were added in January, thereby reducing the unemployment rate to 8.3%. While this can be viewed as a bullish indicator heading into the future, we must be aware that unemployment often is not a true indicator of what the jobs picture in the economy actually looks like. A reduction in jobless claims, as well as a reduction in total people in the workforce, can artificially improve the unemployment rate, and the BLS can also massage the data. Nevertheless, it seems fair to assert that investors have viewed the falling unemployment rate as a positive indicator in devising their market outlooks and constructing their portfolios. Specifically, Treasury yields have risen recently, which suggests that PM’s are adopting a more risk-on mentality. Defensive, dividend-yielding stocks have fallen out of favor to a certain degree, as investors have favored more cyclical, growth companies. Insofar as the Federal Reserve, Bernanke announced they will keep interest rates low until 2014 or later in an effort to continue to encourage borrowing, capital investments, and spending, all aimed at sparking further economic growth and ventures to riskier assets. Whether or not the Fed retraces this sentiment in the midst of unsuspected economic strength to begin the year remains to be seen. One must wonder whether inflation risk will come to the forefront due to low rates across the curve. If unemployment remains high with seemingly low inflation of roughly 2%, then QE3  becomes more likely. The Fed previously announced they would be willing to purchase MBSs if necessary to provide fresh liquidity, but as the economy improves this possibility lessens. At the very least, a double dip now seems very unlikely, even for the perma-bears. Another recent development that has garnered attention is Facebook’s announcement of an IPO seeking a 75 to 100 billion dollar valuation. This would result in a P/E ratio of 100, roughly 3X that of tech stalwart Google in 2004. Their ability to drive EPS has come into question, as they would need to expand their business model to develop profit generators beyond online advertisements in order to justify such a high valuation.

Europe:

Politicians in Europe continue to “kick the can down the road” with grandstanding, postponing, and a general lack of cooperation regarding Greece. The ECB has provided a 3-year LTRO to banks in need of aid, which has quelled concerns recently of a credit crunch. Greece, though, faces a March 20 deadline of 14.5 billion Euros coming due, and lacks the ability to pay its bondholders. Greece is dependent on implementing a “collective action clause” for private creditors (mainly hedge funds) to agree to an up to 70% haircut, with longer-termed bonds and lower yield, which they’re unwilling to do because their protection (CDS) then wouldn’t be triggered. It will be interesting to see how this standoff will resolve itself, as we’ve heard news of an imminent solution for up to a month at this point. A domino effect may ensue as debt contagion spreads, which certainly seemed probable towards the latter part of 2011.  Real fiscal reform is necessary, but the two-tiered Euro Zone that has emerged makes the probability of cooperation much lower. Simply put, Greece will default; at this point it’s only a matter of whether it’s orderly or disorderly. In previous essays, I have advocated letting Greece default, as they are simply insolvent with a 160% debt-to-GDP ratio. Continuing to pump money into a nation with such a toxic balance sheet seems illogical to me. Retroactively implementing CAC’s can erode confidence in the market as well. If this precedent is allowed to be set, other debt-ridden nations would likely want to follow suit. All things considered, we will see further infusions of liquidity with injections of loans of up to 500 billion or more Euros from the ECB in the near future. This easing does not solve the underlying problem, which is unfeasible debt levels; it merely places a Band-Aid over the problem. Until growth occurs, and fiscal reform and prudency is implemented, as previously mentioned, we will likely continue to see Euro Zone perils. On the more positive side, Italy has seemed to have stabilized for the time being, according to PM Mario Monti, but Portugal’s rising benchmark yields has emerged as an even greater concern. Spanish unemployment, similarly, has reached 22%, which provides evidence that Europe may face a deep, rather than mild, recession. The implications of a deep European recession on the U.S. could be crippling. Such an event would significantly affect the U.S. in terms of real exports and also from a psychological perspective. Further, the breakdown of such an interconnected global financial system would severely threaten large U.S. banks, whose exposure to European sovereign debt could be significant, as noted by JPM CEO Jamie Dimon. Bernake asserts that he will do all he can to shield a vulnerable U.S. from catastrophic effects from the Euro Zone, but the decoupling theory, in my opinion, fails to hold water on all levels. Sooner or later (March 20 to be exact) we will yet again find ourselves on the precipice of cataclysmic collapse. Staying defensive at this point, and viewing the rally with a critical, if contrarian, disposition, would likely be a wise decision right now because of the aforementioned potential headwinds.