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Sideways Consolidation Before The Next Downleg?
By: Cam Hui   Monday, October 10, 2011 10:56 AM
The future of the euro is now not in their hands, because by taking on the debt they did not blow the euro up. Which could have happened, because European politicians were not ready for such a crisis.

So rather than having to kick the door open for a haircut, they expect the door to be opened for them by the IMF and the ECB. A far more respectable path for those who are very pro-Eurozone. But Irish leaders clearly get that voters expect that something will be done. They have time, as it will be another three-plus years before elections. By then, the crisis will have fully evolved and resolved itself, as far as the political public is concerned. And politicians will take the credit, as they always and everywhere do. Then don't forget Portugal, Cypress...

An imminent American recession
Across the Atlantic, the recent ECRI recession call was notable in that their model has not had a false positive in its history, which is quite an accomplishment. More puzzling is the recent flow of economic data, which has been weak, but not at recessionary levels.
Bruce Krasting has an interesting five-Friday hypothesis as an explanation for the recent non-recessionary data points. September 2011 had five Fridays. For workers who get paid every two weeks, this meant that they got paid three times in September - which would have distorted the data. Krasting went on the point out that October 2010 had five Fridays, whereas October 2011 has four Fridays. If the "five Friday effect" was the main cause of the distortion in the economic data, then we are likely to get a negative surprise when the October figures get released about a month from now.
My medium term outlook remains the same. I agree with seasoned analysts like John Hussman and ECRI that a US recession is baked in. In that case, earnings are likely to come down 20 percent to 40 percent as per James Bianco. If we were to see a market panic, trailing market P/Es could hit as low as 10, which means that U.S. equities have the potential to revisit their 2009 lows.

What about China?
Then we need to consider the China wild card. As I pointed out in my commentary last week, the markets will start to price in the possibility of a Chinese landing as the American and European economies weaken into recession. Already, we are seeing headlines about a credit crunch in China and Chinese home prices dropping for the first time in a year. These developments are particularly worrying as the shadow banking system in China has grown by leaps and bounds, which is creating a Chinese subprime-like problem (see one discussion here). Significantly more negative developments out of China or other emerging market countries could throw a fright into equity markets and other risky asset classes.

Inner investor still defensive, inner trader mildly bearish
My inner investor tells me that a financial winter is coming but there is no need to panic. Just as spring follows winter, the global economy will heal itself and investors can survive and prosper again. Have a plan to manage your way through such periods of market volatility. With that in mind, he offers the following suggestions:

  • Be the predator and not the prey: Food is scarce in winter and predators will take the opportunity to pick off weakened prey. Should the markets panic, asset prices will sell off into unreasonably cheap levels as weakened investors raise cash to meet margin calls, or worse, pay their bills. If you are sufficiently liquid and have sufficient resources, then there will be great opportunities to pick up assets at distress prices as the weak sell to the strong. At the very least, make sure that you are not the weakened prey.
  • Store food for the winter: From a tactical viewpoint, either get more liquid or take positions in default-free US Treasury bonds whose prices are expected to rally from a rush into safe haven assets. A Canadian investor with a US Treasury bond position has even greater upside potential because the Canadian Dollar is likely to weaken against the US Dollar in such an environment. I use the Asset Inflation-Deflation Timer Model to time my entry and exit points.
  • Be opportunistically prepared to buy: Looking longer term, the Fed and other central banks will react to deflation. Low or negative real interest rates generally signal a friendly investment environment for commodity prices. Continued government and/or central bank accommodative policy responses will likely push real interest rates even lower and add to even more future asset inflation. Investors who are opportunistic or prepared to look over the valley can view periods of market weakness as opportunities to accumulate positions in commodities or commodity producers as a hedge against asset inflation.
My inner trader, on the other hand, is moving to a more neutral, though bearish, stance in wait for the next major move. He believes that near term volatility is highly likely and headline driven.

As BCA Research (via The Economist) points out, under these current conditions of European uncertainty the demand curve for periphery bonds is not necessarily well-behaved (i.e. monotonically downward sloping) but can twist and therefore multiple equilibria is possible. Hence the volatility depending on news. changing risk preferences and shifts in sentiment.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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