PORTFOLIO POINT: Now is the time to be wary of equities and nurture your cash. The worst you could suffer is missing the beginning of a rally.
On Saturday morning I told Eureka Report readers that I think there is a clear danger of another significant downward leg in the sharemarket. I don’t know when this will happen, and it is by no means a certainty (because nothing in life is a certainty), but in my view the risk is such that those who have not yet moved to a more defensive stance with their investment portfolio should do so now.
Today I want to explain why I could be wrong. There are two reasons:
- Long-only institutions looking for healthier December quarter return could put the squeeze on short-sellers and force them to cover, driving prices up before the end of the month. I don’t put much store in this, but it’s possible and it would only put off the inevitable crunch anyway.
- The European Central Bank could reverse its current policy and go for all-out money-printing to support floundering sovereign borrowers and banks.
To some extent all of the financial markets have become a gigantic three-way tussle between the longs, the shorts and the arbitrageurs, each trying to rob the other.
In the United States at least half the volume on the stockmarket is accounted for by high-frequency computer traders who are looking for minute pricing differences. Here it’s a bit less but still significant.
At various times the long-only institutional investors dominate the market and at others the long/short hedge funds are in the ascendancy. Short positions are at very high levels at present because of the widespread conviction that the market will head lower.
So far this quarter, the ASX 200 Accumulation index has provided a total return of 4.5%. That’s an annualised rate of return of 18%, which is fine, and a lot better than the previous quarter’s minus 11.6%.
In the light of that there may not be much of an imperative to put on a short squeeze to “dress up” the December quarter figures, but there may be an attempt to get back a larger part of what was lost in the September quarter.
As for the second reason that I might be wrong – no one would be happier than me if it came true. The consequences of Europe not dealing effectively with the developing sovereign debt and banking crisis would be far worse than the effect on my puny super fund.
If the ECB decides to buy sovereign bonds and recapitalise European banks WITHOUT LIMIT (as I believe it needs to do) then the sharemarket would probably stage a spectacular rally, my warning of a major panic sell-off would turn out to be wrong and we would miss a few percentage points of the rally.
Think about that: the risk is all to the downside; if you protect your capital by moving it to safe cash you remove that risk; if you’re wrong and the market rallies, the worst that happens is that you miss some of the rally.
I have believed for a while, and still believe, that the ECB will act to inflate away Europe’s debts since the consequences of not doing so are so horrendous, but so far there few signs that it will.
Even if it does act, and there is a big rally, that would not necessarily mean the bear market is over.
In my view, the process of deleveraging the world economy and “mean reversion” on financial markets still has a long way to run. Sharemarket valuations look low compared to the past 10 years, but, as I have often pointed out, on some measures stocks are still expensive.
Specifically the Q Ratio (sharemarket value as a proportion of total replacement cost) still has the US S&P 500 15% above replacement cost. In the past it has usually bottomed out at 50% below replacement cost.
Moreover, during previous credit busts, average price/earnings (P/E) multiples have been between five and 10 times for extended periods. Currently the average market’s P/E is about 12 times, although a growing number of stocks are now below 10.
Sharemarkets tend to anticipate economic growth by about six months and are sometimes said to pick 10 out of every five recoveries.
It’s now clear that the big rally of 2009 anticipated an economic recovery that did not arrive and as a result the bear market has resumed.
Although the market will react up or down according to the latest news out of the ECB, and whether it decides to print unlimited amounts of money, the fundamental issue has to do with economic growth, in Europe, the United States and China.
Europe and the US simply have too much debt and are in a bind: growth is insufficient for them to repay the debt, but the austerity required to pay it off removes the potential for growth and causes tremendous social problems.
The only other ways to eliminate the debt are to default, which would potentially destroy the financial system; or to print money and inflate prices, thereby forcing savers to pay. That’s the course decided on by the US and the UK.
At this stage, Germany and the ECB are refusing to contemplate the last of the three options and are trying to force austerity on the debtor countries of Europe. That course of action means Europe is in for years of low growth and recession, possibly Depression-levels of unemployment. The political and social problems that this would unleash threatens the second option – default.
It is this dynamic that prompted Saturday’s warning of a possible major correction. The market has not really contemplated this outcome. It corrected by 15% in August to account for the prospect of a Greek default, but the potential default of Italy, Spain and, eventually even France, is not yet in the market.
That’s why I think we should be prepared for another panic sell-off. But I could be wrong.