TOP 4 LESSONS FOR THE COMING WEEKS: HOW MUCH UPSIDE LEFT?

Last Week’s Market Movers And What They Tell Us For The Coming Weeks About Stocks, Currencies, And Other Global Markets

First, let’s quickly review the prior week in global markets. Then we look at the top 4 lessons to take into the coming weeks, and how to apply them, regardless of how you trade or invest.

SUMMARY TOP MARKET MOVERS WEEK OF DECEMBER 17-21

Once again, markets moved with shifts in hopes for new stimulus from Japan and the US. Specifically:

  • Japan:  That the new elections would produce a more pro-stimulus administration that would be strong enough to force the Bank of Japan to further easing beyond what has been expected.
  • US: That there would be a deal on the fiscal cliff,  the coming wave of tax increases and spending cuts due to take effect in 2013, which would be pro-stimulus by mostly deferring these austerity steps to a later date.

Here’s how things went day by day, followed by our take on the lessons implied for this week and beyond.

DAILY BREAKDOWN

First let’s clarify a few terms, because I’ve been seeing some confusion from the comments to recent articles.

Key Terms

1. Risk Versus Safe Haven Assets

Unless otherwise noted, when we refer to risk assets we refer to assets that rise with optimism and fall on pessimism about future growth. Safe haven assets perform in the opposite direction. Understanding the distinction between these two asset types and what drives them is fundamental and critical for understanding how, why, and when markets move as they do.

To get a quick and solid background on this topic, you can view pages 19, 29, 70, 170, and 176 of my book free of charge on its amazon page. Just place your mouse pointer on the Click to Look Inside feature, select the Table of Contents, and scroll down and click on these pages.

Those interested in more detail can select the Index and scroll down to Risk-to-safety spectrum. We all owe a big thanks to my editor Laura Walsh at Wiley & Sons publishers for allowing a uniquely detailed table of contents to facilitate these kinds of searches.

2. Bullish Versus Bearish

When we use the term bullish, unless otherwise noted we mean positive for risk assets in general and negative for safe haven assets. Bearish means the opposite of bullish.

Daily Breakdown

Ok, with terminology reviewed, we proceed with a breakdown of what moved markets each day last week and conclude with lessons for the coming week and beyond.

Monday

Stimulus Hopes in For Japan and US: Japan’s pro-stimulus LDP did better than expected in elections and won a supermajority in the legislature, raising hopes for a bigger coming stimulus package. In the near future, that would benefit risk assets in general, Japanese exporters (and anything tied to them like suppliers or overseas vendors) in particular, and lower the JPY. In the US risk assets were up on optimism on fiscal cliff deal based on nothing in particular. Most Asian and European indexes (good barometers of overall risk appetite) were mixed-to-lower, while Japan and the US were up solidly.

Tuesday

Asia, Europe, US all higher on improved hopes for stimulus in Japan and the especially in the US, as there were signs of progress towards a deal, as both President Obama and Republican  House Speaker Boehner appeared to be moving closer.

•              President Obama offered to raise the threshold for tax increases to those earning $400k. That offer, compared to the $250k threshold which was a part of his presidential campaign tax policy, that concession was a significant.

•              House Speaker Boehner also offered a significant concession, saying he would introduce a bill that would include tax hikes for those making over $1 million.  “Our Plan B would protect American taxpayers who make $1 million or less.”

Meanwhile the EUR rally continued, with the EURUSD making its biggest move higher for the week. See our weekly EURUSD outlook for reasons behind the ongoing rally, what will stop it, and its ramifications for other markets, here [??fill in w/ link]

Wednesday

Asia and Europe market were up on the same stimulus hopes mentioned from Wednesday, and Europe got some help from positive German Ifo business climate report. However, the US closed lower as those hopes for fiscal cliff deal faded when Obama rejected the Republican budget proposals. Soft US housing data didn’t help. However, just as with the German Ifo news, this was another case of how data only mattered if it reinforced the direction of sentiment based on Japan or US fiscal cliff stimulus hopes.

Thursday

It was more of the same Thursday, with Asia down in delayed reaction to the US fiscal cliff deal setback, and also signs of resistance to new stimulus from the BoJ. Europe closed flat and the US was modestly up due to a lack of new negative fiscal cliff news and positive existing home sales, manufacturing, and final GDP figures.

Friday

Asia, Europe and US markets were all down as the US fiscal cliff deadlock and recess in Congress until December 27th cut the likelihood of a deal before the year’s end, risking a selloff next week as investors are tempted to take profits and reduce risk ahead of the Christmas holidays. Still, the move lower simply retraced the prior day’s gains, and so was not large enough to suggest any notable worry yet.

LESSONS

1. Markets Moving Only On Short Term Outlook

As noted at the top, markets are moving on nothing but prospects for further short term rallies from ongoing and growing easing, rising deficits, and money printing. That’s it.

Of course in both cases of Japan and the US, the short term gain comes at a cost of rising deficits and greater future pain.

Even at today’s historically low interest rates, just the annual interest owed on national debt is over 25% of Japan’s budget, and about 20% for the US. That makes the eventual raising of rates very problematic, because any spike in rates will break their budgets, unless these governments of course just keep printing.

Eventually however, that same printing solution undermines the very confidence in these currencies that’s required to keep their bond yields and borrowing costs affordable.

If that confidence goes, then even the printing presses can’t save Japan and the US from being as insolvent as Greece.

While both nations can of course print all the money they need to make these payments, at some point their currencies become so debased that they risk hyperinflation that’s as fatal a threat to public and private solvency as excessive debt.

Meanwhile however, markets are focused on the short term gain, rising on news that feeds hopes for new easing and short term rallies, and falling on the opposite news.

The idea that markets are forward-looking 6-9 months just doesn’t hold true at this time.

2. Markets Still Have Faith In Fiscal Cliff Deal That’s Light On Austerity

Markets remain well within recent trading ranges, despite disappointment over the rising risk of no yearend fiscal cliff deal. That suggests ongoing calm that could prevail even into the early weeks of 2013. So while the fiscal cliff deadlock limits upside potential for next week, downside potential for stocks and other risk assets also remains limited for now as markets appear unsurprised by the delays in reaching a deal.

Given the similar delays and brinksmanship displayed on the debt ceiling deal in the summer of 2011, this attitude is well justified, and explain the blasé attitude markets continue to take that a deal will be done and that the deadlock is just for the benefit of local constituencies.

Some Republicans are up for re-election in January and so are likely to oppose any compromise that could alienate voters. Those political considerations increase the odds of a deal until the latter part of January.

3. Big Lesson #1: Markets Remain Overbought

As we’ve mentioned in prior weeks, the S&P 500 index remains less than 10% below its decade-highs, as do most risk appetite barometers, despite underlying market  fundamentals being far weaker than they were in mid 2007, before the Great Recession hit in the wake of the US and EU debt crises. These weaknesses include:

  • Continued weak global growth data and corporate earnings.
  • The fiscal cliff deal can only offer a brief relief rally. Even when a fiscal cliff deal is reached, the most near term bullish case possible is that there is NO improvement in the current tax and spending situation, and that all tax cuts and spending increases that were there in 2012 remain in place. Few believe that will happen. Rather there will be at least some new austerity measures, and the US economy will have additional headwinds to growth. Thus the only longer term bullish influence that the fiscal cliff deal can provide is the removal of uncertainty. At best that brings a brief relief rally. However, the fiscal cliff deal could just as easily prompt a “sell-the-news” pullback.
  • The unresolved solvency crisis in the EU. Forget for now the potential for trouble from a Cyprus bailout (remember that one?)Even ECB President Draghi admits that the EU has done nothing over the past years but buy time to devise as yet nonexistent solutions to the current sovereign and banking system insolvency risks . The OMT and every other program in the EU remains essentially some combination of:
    • Lending more money to those who can’t carry their current debt load
    • Optimistic assumptions about future improvements in GIIPS nations’ growth rate that may or may not be true, so these nations are at least as likely to deteriorate as recover
    • Plans to print money out of thin air in order to fund GIIPS bond purchases by the ECB and assorted national banks which in turn keep sovereign borrowing costs acceptably low, so that they can borrow yet more money (again, when they can’t afford their current debt loads)
    • Assumptions that funding nation voters  and tax payers will accept continued transfers to debtor nations and debasement of their common currency and any assets denominated in them

 

The most likely bullish event for the EU in the near future is a Spain bailout under the OMT program. Like the fiscal cliff deal, that can only provide at best a brief relief rally. It too means more debt and money printing, not any actual wealth creation or debt relief.

 

Risk asset prices have recovered solely due to the unprecedented degree of  coordinated support from the central banks of the world’s largest economies, including the Fed, ECB, BoJ, and PBOC. Those measures are only meant to buy time. They are not solutions because don’t create real wealth needed for a self sustaining recovery.

 

So with markets already near likely strong technical resistance and lacking the fundamentals to break higher….

There is limited upside for risk assets for the coming months, probably longer. Long positions in risk assets are either for:

 

  1. Short term traders
  2. Long term income investors with multi-year holding periods using cash they don’t anticipate needing and who need income current income now. Income investors who can afford to wait for better entry points are likely to do better. With moderate risk stocks paying 3-5%, and a selloff from the current near-decade highs of more than that likely at some point in the coming year (see our post on the coming week here), there’s little reason to take new long positions for income at this time.

Regular followers should stay tuned. We’re putting together out list of income plays in the right currencies, sectors, and entry points to have ready when markets show better value. Like David Rosenberg says here, in this environment, for longer term investors, it’s all about safety and income at a reasonable price (SIRP).

We hope to publish more on this idea too as too in our coming articles on

  • 2012:The big lessons
  • 2013: Forecasts, key themes and ideas

4. Big Lesson #2: Limit Long Term Exposure To Currencies Of Loose Central Banks

Meanwhile the US, EU and Japan all plan to muddle through with more money printing and borrowing.

That means that at some point, the USD, EUR, and JPY (and other currencies subject to similar central bank policies) are going down versus better managed currencies and hard assets. They will drag down anything denominated in these currencies. Holding these for the long term is just too dangerous, regardless of what your local financial authorities tell you.

For those with most of their assets linked to these currencies, it’s time to prepare and diversify into safer currencies and assets linked to them.

Until recently, finding these currency diversification solutions hasn’t been easy.

  • Most forex guides focus on trading styles that are too risky and demanding for most people.
  • Most foreign investing guides focus on the fundamentals of a given recommended asset without giving enough consideration to the currency to which they’re linked.

For the most updated collection of simpler, safer solutions to suit a wide range of needs, skill levels, preferences and risk tolerances, see here or here.

DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.

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