Reality Bites

And so the penny drops…

From the Wall Street Journal:

Investors around the globe retreated from stocks following a turn toward political upheaval in Italy, with the Dow industrials dropping nearly 400 points and U.S. Treasury yields posting their largest daily decline in nearly two years.

Six years after the eurozone stepped back from the brink of a breakdown, a violent selloff in southern European debt bled into broader financial markets. Investors sought the safety of the U.S. dollar and the Japanese yen, which rallied sharply.’

This has been bubbling away for a while. Italy had its elections in early March. Yet investors in Italian government debt saw no problems with the result, with yields remaining negative (meaning investors paid the Italian government a small fee to lend them money) until just a few weeks ago.

Seriously, the Italian government hadn’t had it so good since the Vatican starting taking cash to ‘open the doors to heaven’.

But now, the market has turned on a dime, as it is wont to do. Yields on Italian and peripheral European debt have jumped sharply. The issue is that Italy hasn’t yet formed a government. This may lead to fresh elections, which in turn could strengthen the hand of the anti-European Union forces.

It’s a replay of the 2012 crisis. The euro is once again facing an existential threat.

To what extent this gathers pace and brings down the rest of the world’s markets is an open question. The bulls will say it’s no big deal, while the bears will say it’s the start of the ‘next crisis’, that thing that’s been brewing since, well, 2009.

Taking neither the bull or bear view, here’s how I see it…

The issue here is politics, and Italian politics at that. Who knows how things will play out? The answer is: no one. That means a big increase in uncertainty, which in turn means a ‘risk-off’ attitude and lower asset prices for the time being.

 

 

The problem for markets in such an environment is that machines determine asset allocations in the short run, and they are just as prone to losing the plot as humans are. Consider this, from Bloomberg:

Rare market gyrations keep cropping up, presenting a challenge to the risk models at financial institutions.

From Italian debt to emerging-market currencies, extreme market moves are taking hold, raising the prospect of forced selling as portfolios adjust to maintain a steady level of risk.

It’s a potential wake-up call for traders lulled by the successive record lows seen across volatility gauges in 2017, and threatens to crimp risk-adjusted returns in unhedged portfolios.

“Things are changing,” said Victor Haghani, founder and chief executive of Elm Partners Management LLC and a founding partner of Long-Term Capital Management LP. “Vigilance is important here. This is a big move in Italy, and big moves in isolated emerging markets.”

The problem is not ‘rare market gyrations’. Rather, the problem is that financial models contain unrealistic assumptions. When the real world screws with those assumptions, it leads to selling, which in turn leads to more selling.

Taking a step back from this latest European flare up, and looking at it in a broader context, it’s another reason to believe that the global bull market topped out in January this year.

To see what I mean, have a look at the chart of the S&P 500, below:

Money Mornings 30-05-18

Source: Bigcharts
[Click to open new window]

It peaked in January before falling sharply in early February. Since then, the world’s largest stock index has struggled.

There are two ways you can interpret this.

One is to say that US stocks are consolidating after a very strong two-year bull run. And that at some point, the bull market will resume and stocks will go on to make new highs.

The other view — and this is the one that I lean towards — is that markets are in a transition phase. The bull market is over, followed by a period of volatility, before the bear market takes over.

The volatility represents an arm wrestle between the bulls, who want the good times to continue, and the bears, who think the good times are over.

Who is right?

You won’t know the answer to that question until it is too late. That’s the annoying thing about markets. You have to make decisions when you don’t know the outcome.

Since late 2017, I’ve warned readers of my Crisis & Opportunity investment advisory that a bear market in 2018 is likely. I still hold that view.

But that doesn’t mean you’ll see another 2008-style meltdown. It just means you should be vigilant about the stocks you buy. Hopping on hot trends from 2017 and waiting for prices to rise won’t cut it.

This is a stock pickers market. And it’s not an easy one…

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing. He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’. That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors. And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis. Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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