Market Update (September 2012)
Thackray Market Letter
by Brooke Thackray, alphaMountain Investments
Super Mario to the rescue! In August, the ECB President Mario Draghi stuck his neck out and claimed the everything possible would be done to save the Euro. Despite the absence of an agreement amongst the EMU countries and no supporting details, investors took him at his word and pushed the markets higher. On September 6th, he announced that the ECB was stepping up with an unlimited bond buying program in the secondary market to help the struggling countries. In addition he announced that the ECB would be pari passu with the private investors on new bond purchases, not have senior credit status over private investors. This is a big step, as previously when the government was seeking investor participation on bond purchases, the more the ECB bought, the worse off the private investors became. He also stated that the bond buys would be linked to “strict and effective conditionality” with the recipients of aid having to meet agreed austerity conditions. In addition, Draghi stated the ECB’s efforts would be focused on debt maturities up to three years. Investors should note that Draghi stated that he has support for his program, but it is not clear that he has full support of all the countries.
Although there is no doubt that this new program is a major step forward, it is not quite as good as first portrayed in the media...... Just like the cell phone companies that claim “unlimited this” and “unlimited that”, it is only when the bill comes in the mail that you realize that the plan you bought into...is not so unlimited.
By announcing an “unlimited” program Draghi is hoping to avoid the pitfalls of the previous programs where investors were able to see the inadequacies of the amounts and structure, and trade against the sovereigns. The word “unlimited” is meant to scare away any investors from betting against the sovereigns. The theory of the big unlimited bazooka is that it will not be seriously challenged because of its fire power, allowing for continued lower yields in the profligate countries.
There are two trading problems with the current “unlimited” program. First, the ECB buying is designed to focus on bonds with a range of one to three years in duration. Naturally, investors are going to see the Maginot Line and attack the sovereigns at the longer part of the curve. This is going to create a steep yield curve and force governments to operate at the short end of the curve.
Typically, and wisely, governments spread their debt out over the yield curve to diversify risk. The current rescue program is going to encourage governments to have a disproportionate amount of obligations at the short end of the curve. This is going to increase the risk of rising interest rates. If rates do increase in the future– a large amount of funds will have to be raised all at once. Oh well....who is worrying about the future, not the ECB, not yet.
Second, do you really think that the bond buying program is unlimited? In theory, the ECB could print as much money as they desire to buy the bonds, but practically this would have a detrimental effect on the Euro. Germany and other countries with strong balance sheets will not be supportive of such inflationary measures. The program will be unlimited up to the point where one or more countries start to realize how costly it has become on their economies and consider leaving voluntarily if the program remains unchecked. This applies to both the receiving and giving countries.
The receiving countries may reevaluate whether they can live with the continued austerity programs and whether it is worth the pain staying in the EU. Some of the giving countries may reconsider staying in the Euro, wondering whether over the long-term they will be slowly dragged down as the profligate countries suck more and more money out of them. It is very conceivable that eventually one or more strong countries leave the euro or perhaps even form their own regional currency. If this were to occur the Euro would still survive and Euro financial obligations could still be met. The profligate countries could then inflate their way into oblivion.
Although Merkel is making bold statements standing behind Draghi, all is not well in Germany. There is a rising number of German citizens and politicians against “unlimited” support – who can blame them. In addition the German courts announce their decision on the legality of Germany’s financial help to the EU. Legal experts have generally taken the stance that the courts will be supportive of the current programs, but with some modifications — but it is the courts after all, and no one really knows the outcome.
There is tough talk about how the countries receiving assistance will have to commit to austerity programs in order to receive support. The reality of the situation is that the current receiving countries have not met their austerity targets and are asking for extensions or more lenient terms. Greece is currently asking that their austerity timeline be bumped from two to four years. More than likely, they will be back later asking for another extension to six years. There is no red-line for the imposed austerity programs and all of the profligate countries know it. It is all a negotiation game.
Investing in an environment where political actions can easily drive the market one way or another is very difficult at best. So far, front running possible announcements has paid off, but as the programs become less effective in boosting he market and the increase in value gets baked into the price earlier and earlier, at some point front running will not pay off. It is difficult to say when this time will occur: it could be six months, or a year, or even later, but it will come.
The FMOC meets this week and a large portion of investors is expecting the Fed to announce another stimulus package. Another stimulus package is probably forthcoming in the near future, but it is difficult to determine if it is going to be this week, or after the election in November. There is no question that the economy has been sluggish in the US, but it has not been disastrous. Bernanke has held off on another QE package, knowing that if he announces too soon, investor expectations of following packages will occur much quicker next time the economy slows down.
Despite my negative comments on the European and US situation, the market can move independently from political events in the short and medium term. In other words investors should remain focused on other factors to make their investment choices, such as, seasonal trends, earnings and the economy.
Market Outlook
The market has had a rare summer time rally, based mostly on the fact that the economy in Europe and the US is bad enough that stimulus would be forthcoming. As I have mentioned before, the market rises often enough into the middle of July, but less often from that point forward. The S&P 500 has just broken above its high of 1422 set in early April. Investors should remember that we still have not finished working our way through the most negative month of the year and risks to the downside remain.
Later this week, September 13th, the Federal Reserve could move the markets by either announcing, or not announcing, another stimulus program. If it does not announce a stimulus program then investors will probably have to wait until after the US election. Also, on September 12th, the German courts are expected to pass judgment on the constitutionality of Germany’s assistance to EMU through the European Stability Mechanism (ESM). The point is that there are two very large variables that could move the markets either way. Given that we are still in the weak seasonal month of September, caution is urged.
Even though the market has moved up from its lows in June, the time to enter into a more aggressive market position will soon be at hand. Despite October having the reputation as being a weak month, since 1950 it has produced an average return of 0.6%% and has been positive 59% of the time. Nevertheless, it does deserve the reputation as the most volatile month.
Volatility can provide opportunities. There are three possible buying zones in October. First, the beginning of October (start of the 18 day Earnings expectation cycle, Thackray’s 2012 Investor’s Guide, see page 43). Second, October 9th (actual buy date at close of market October 8th), is also another rally point as the market can often surge if it has corrected coming into this time period. Also, technology stocks tend to start their outperformance at this time. Third, October 28th (actual buy date at close of market October 27th), is the classic long-term buy date kicking of the favourable six month seasonal cycle.
There is no guarantee that any of these three dates will prove to be opportune, but the market often provides a good opportunity for increasing equities during October. Investors should be actively looking for entry points. Last year the beginning of October presented itself to be an opportune time for market entry, as the market started to rally on October 3rd. In the first week of October HAC started to commit more money to the markets. The market went on to reach a short-term peak on October 28th, before correcting in November and then rallying once again.
It is difficult to develop a strategy for the best entry point during the month of October. Nevertheless, seasonal investors should have a bias to increasing equity exposure in October. The beginning of October could present an attractive entry point if the market corrects severely during the rest of September, setting up for a bounce in October. If the market muddles through into October it will be more vulnerable to a pullback in the middle of October (19th to 27th), when the market often has large downdrafts. Although technical analysis can help fine tune the entry dates, investors should be disposed to enter the market before the end of the month.
