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Rodrigo C. Serrano New York, NY Direct 305-510-0181 Email Uformula.firstname.lastname@example.org Websites: http://rcsinvestments.wordpress.com http://rationalcapitalistspeculator.tumblr.com http://www.linkedin.com/pub/rodrigogserrano
Market Outlook (Mid- 2012)
July 5, 2012
Executive Macro Summary Globalization’s dark side has arrived. The global economy is currently held hostage by a political crisis in the Eurozone, critically harming the already weak foundations of the global recovery. Fiscal prescriptions demanded by Germany and other core-countries have led to recessions throughout the periphery, along with increasing nationalism. While last week’s announcement for a euro-wide banking regulator, to be instituted by the end of the year, drew worldwide acclaim and caused a powerful rally in risk markets, the accord is unlikely to eliminate the festering wound threatening our global economy. There’s a dangerously high probability that Europe’s announcement has come too late and that European officials will find themselves obligated to take very uncomfortable and hurried steps towards fiscal union in the months to come. Meanwhile ongoing austerity in Europe has led to a “larger than expected” slowing in China, as the export-dependent country’s largest client is falling into a deep recession. Chinese officials have instituted policies aimed at both subduing the country’s buoyant real estate market and moderating inflation. With no significant stimulus on tap, I am skeptical that the communist country can withstand an exogenous economic and financial shock emanating from the Eurozone. Finally the Eurozone crisis has begun to affect U.S. consumers and businesses. Confidence and clarity in future growth have diminished. Job creation and business investment have slowed. The national savings rate just hit a 4-month high and is a testament to the growing worry over events transpiring across the Atlantic. We are currently in the midst of a crisis of confidence, which may lead to the self-fulfilling prophecy of global recession. The coming year may mark the next disorderly phase (2008 was the first) of what I’ve called the “Global Economic Restructuring” process; which has been the fundamental macro trend to recognize and track over the past few years. Continued intervention and manipulation on the part of political and monetary officials have delayed this adjustment and in fact have
worsened today’s large imbalances. Indeed, they have created an uncertain environment, damaging confidence for long-term investment. To be sure, government officials will likely continue to intervene in our capital markets should economic conditions continue to deteriorate. These actions may cause bullish shifts in sentiment as well as powerful relief rallies, especially given that investors have grown to embrace central bank intervention as a panacea. However, in the absence of significant fiscal stimulus (both in the U.S. and Europe), monetary authorities may find themselves unable to stop the eventual process of restructuring that needs to take place. The coming years are likely to remain turbulent as China continues on its course to become the “world’s consumer,” as the U.S. was for many decades, while the U.S. and most of Europe retool their economies to feed China’s eventual insatiable consumer demand. There are wildcards in regard to the long-term direction of the global economy however, the most significant being in the presidential election this coming November. Regardless, if world leaders can successfully navigate the treacherous waters of global restructuring over the coming years, eventually today’s seemingly endless period of weak economic performance will lay the foundation for a powerful secular bull market that may last for decades. Until then, investing today will require flexibility, risk management, and a willingness to embrace the fact that buy-and-hold investing has taken a back seat for the time being. ------------------------------------------Current Investment Environment Both bulls and bears are wrestling for control of U.S. equity markets. Recently Europe announced a solid step forward towards fiscal union, agreeing to institute a region-wide banking regulator by the end of the year, while core-countries allowed the use of bailout funds for direct capital injections to ailing banks. Officials also renounced the preferred status of the bailout funds vs. peripheral sovereign debt, putting to rest the lingering concern of seniority over sovereign bondholders. In the U.S., the housing market has provided for increased optimism that the worse is finally over for the real estate market. The job market, while slowing, is showing signs of resiliency. Alternatively confidence in any Eurozone solution has waned markedly after 19, 20 (lost count) summits without a sustainable resolution. Moreover, economic data has been depression-like in the Greek and Spanish economies, while Germany is showing signs of infection. Finally, Eurozone austerity is having a profound effect on the Chinese economy and may be hitting U.S. shores given last week’s ISM manufacturing data.
What will be pivotal in the coming weeks and months is if Eurozone officials successfully convince investors that plans announced at the latest summit are plausible and will be implemented. Investors are on edge and confidence remains fragile. News of stabilization in China or a reacceleration of the U.S. recovery would entertain optimism and could push Eurozone concerns to the backburner until the end of the year. Outlook I don’t have sanguine expectations for a market-friendly solution in Europe and remain cautiously bearish on the outlook. While the results of the summit were encouraging, they contained no immediate actionable items, only promises. Funds from the EFSF/ESM will likely be unavailable until a region-wide banking regulator is set up…by the end of the year. Officials may not have until then. Confidence is falling and economic activity seems to be following suit; deteriorating data is reducing confidence even more. A negative feedback loop is developing. Ironically, buying time is becoming counterproductive, as continued austerity promotes weakness and misery, sapping political will and promoting disunity. A strengthening negative feedback loop may ignite a crisis of confidence and spark a rush to the nearest exit. With an elevated likelihood of an exogenous shock from Europe, I remain cautiously bearish on China as well. Meanwhile at home, earnings growth has decreased markedly and earnings estimates have been trending lower for most of the year. Furthermore, margins are at historically high levels and likely signal that gains due to productivity have ended. Given further slowing in the global economy, there’s a high probability that earnings have peaked for the cycle. Sentiment wise, there is increasing bearishness; however, there are signs that investors remain too optimistic for what may come around the bend. The underlying hope that Europe will take care of business still remains, as does the seemingly unflappable belief that further quantitative easing will juice risk markets. I am increasingly skeptical. There is a growing realization that quantitative easing has not produced a sustainable recovery and that its costs outweigh the benefits, both in the economy and the markets. Further, how effective will monetary stimulus be in the face of a contraction in fiscal policy? Should the Eurozone splinter, I fully expect another quantitative easing operation, which is likely to produce a strong short covering rally. However, in the absence of expansionary fiscal policy and strong growth in the global economy, will it really make a difference in the fundamental picture? More importantly, will investors see it as a difference-maker after two false dawns? ------------------------------------------
High Conviction Investments US-Dollar Bull: The dollar has rallied 6% since my bullish call in October 20, 2010 and 1.7% since the beginning of the year. Increasing uncertainty, weakening global growth, and the high risk of a financial shock make the dollar an appealing investment over the short-term. While more QE would act as a headwind for further dollar appreciation, the circumstances of a QE would likely entail a fragmented euro zone or Chinese hard landing; these events occurring would make dollars coveted anyways. Stop-loss: 78.00
10-Yr U.S Treasury Bull: 10-yr Treasuries have come a long way and I have been fortunate to recognize the correct trend since February 2011 (a +60% rise in DTYL). I believe we have further to run in what has been a powerful secular bull market for Treasuries in general. The threat of a negative surprise from the Eurozone, weakening economic growth, continued hate from investors make U.S. paper intriguing. Once China is close to a sustainable recovery led by consumption, I’ll be more cautious of Treasuries. Stop loss = 2.45% (Rising yields = falling Treasury price) or 61.90 in DTYL
S&P 500 Bearish: The equity market has showed continued resiliency and has been unexpected considering the worsening macro backdrop. In the quick run up during the beginning months of the year, I was stopped out of some of my short positions. However, I now look to further increase my downside exposure again as the probability for a positive market solution in Europe is dangerously low. Furthermore, weak economic data may cause investors to announce, “that’s enough!” and spark a period of rushed selling. I feel that equity markets are ready to run. A break out of multi-month triangle is indeed a bullish omen; however, I still remain skeptical of the (improved?) short-term outlook. Either way, a medium-term long-straddle option strategy for the SPY (long a call and a put on same exercise price) looks to be an interesting strategy to employ. Buy Stop for SPY = 142.70
Please see the following page for a more detailed picture of my portfolio allocations.
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