“We are about to embark on a momentous experiment to discover which of the two stories about the economy is true. If, in fact, fiscal consolidation proves to be the royal road to recovery and fast growth then we might as well bury Keynes once and for all. If however, the financial markets and their political fuglemen turn out to be as “super-asinine” as Keynes thought they were, then the challenge that financial power poses to good government has to be squarely faced.”
Lord Robert Skidelsky, FT, “Once again we must ask: ‘Who governs?’”, June 15, 2010
The transitional nature of this stock market fits perfectly with the transitional nature of the global economy – are we headed for the virtuous circle of sustained economic growth or will the decision to withdraw fiscal stimulus advocated by the G20 members result in a double dip (or worse)? The early answers to this question will not be found in the present but in the near future – specifically the third quarter of this year.
Once we get the at-to-slightly-above-consensus 2Q10 earnings results out of the way, most of the focus will shift to the third quarter. Early into the third quarter, macro economic reports will provide an advance notice of what lies ahead for 3Q10 earnings. If the traditionally trained economists are correct, 3Q10 economic results should present no problem and come in at or above consensus expectations thereby ensuring that 3Q10 earnings results will meet the current optimistic projections.
If, however, third quarter macro economic data issued week after week produce below consensus results, then 3Q10 earnings results are nearly certain to come under expectations. Then the fun begins.
Stock Market Signals
All this would coincide with stock market action that will reflect a resolution of the sideways performance exhibited by virtually all indices since the fall of last year. This resolution will present itself in the all-important Mega Trend. If the Mega Trend* reasserts itself with price moving back above both key moving averages AND in the process reverses the recent bearish Mega Trend signals from Europe, then the trading range of the past 8 months has been a consolidation range, the bull market is back in gear, and the real economy will likely not suffer a double dip (or worse).
If, however, the Mega Trend in the US and Asia follows the lead of Europe and produces a bearish reversal signal, then it’s game over – the real economy outcome will likely be something far worse than a double dip.
Investment Strategy Implications
Going into the third quarter, investors who subscribe to the above have two choices: Bold or Cautious.
Bold would recommend a 100% exposure to equities. Cautious would suggest a 60 to 80% equity exposure. While both approaches stand at the ready to shift gears should a bearish outcome become evident, I believe there are two advantages to choosing the cautious stance.
First, any near term decline (i.e., a move to the lower end of the trading range, which is 1000 to 1050 in the S&P 500) would generate a negative return but positive alpha, while any near term advance (i.e., a move to the top end of the trading range, which is 1150 to 1220 in the S&P 500) would produce a positive return but negative alpha. A form of portfolio insurance, if you will. Secondly, and perhaps most importantly, a cautious approach keeps the mind focused on the worse case scenario and will help facilitate rapid action once the below consensus economic readings start filtering in and the bearish Mega Trend signals are generated.
Stocks do not trade in a range indefinitely. A resolution to the upside would say that the trading range was a consolidation, that the bull market will resume, that global markets that had been weak were temporary, that the economic handoff of government spending to private sector sustainable growth has been successful, that the virtuous circle has taken hold, and that earnings and other key inputs into the valuation process will be better tomorrow than they are today.
Alternatively, a resolution to the downside would declare that the trading range was a distributional top, that global markets that had been weak were a warning sign, that the economic handoff of government spending to private sector sustainable growth has not fully occurred, that the virtuous circle has not fully taken hold, and that earnings and other key inputs into the valuation process point toward a tomorrow that will be worse (I would argue far worse) than they are today.
Alfred E. Neuman Would Be Proud
If there is anything to be learned from the recent crises it is that incremental thinking to rapidly deteriorating situations produce catastrophic results. Here’s a partial list:
• It’s only a subprime mortgage problem
• The banking crisis is contained to the financial sector
• Greece is a very small part of the European economy
• It’s just an oil spill, a leak
With virtually no margin for error this time around (as in extremely limited government flexibility), any economic deceleration or decline could snowball rather quickly. The wrong thing at precisely the wrong time. Partying like it's 1937.
All That Jazz
The quote from Lord Skidelsky above says it well - we are about to embark on a grand experiment, we will improvise as we go along, we are confident in our experts, we have faith in our meritocracy, we are BP.
Will this work? We will find out soon enough.
*Use the search function at the top left of this page for prior blog postings on the Mega Trend.