In double-dip territory?

There is ongoing debate as to whether the economies of both the U.S. and Europe have re-entered a recession, but the real question should be whether it ever got out of one! We unfortunately will not know for sure for at least a couple of years to come because of the tremendous adjustments lag between the initial data collecting and the final official figure. There are, however, strong clues that the recession that began soon after the sub-prime crisis erupted in 2007 is still around. The only reason why markets were rallying in 2009 and 2010 were because of the massive concerted government efforts to keep their respective economies afloat. A bull in a bear market if you will but, as the ammunition is being rapidly depleted, the effects of this are reverberated across the financial spectrum. Volatility is rising sharply, commodity prices are dropping and treasury yields, the ultimate safe haven investment (despite the downgrade), is at record lows. So from a technical standpoint, there is growing evidence to suggest that what we are experiencing is not a double-dip or "W" type of recession but more like a very extended "U" type. The rally in 2009 and 10 were just smokescreens and the markets are just discovering that now.

What the sectors are telling us...

A cursory look at stock market sector performances can provide a good sense of the current market sentiment. The graph above measures the year to date performances of the major sectors of the world economy and is not distorted by currency fluctuations.

As a first observation, it is interesting to note the wide performance divergences between the various sectors. There is, for example, more than a 20% difference between the best (health care) and worst (financials) performing sectors. This tends to occur in periods of uncertainty.

The next interesting observation would be the divergence between cyclical and defensive sectors. The better performers (health care, consumer staples) tend to be the defensive sectors which would indicated very bearish sentiment in the markets.

It should come as no surprise that financials are suffering the most considering the uncertainty facing European banks exposed to the sovereign debt of troubled euro zone peripheral countries. What is more curious, however, is the relatively strong positioning of sectors like information technology or energy. For the tech sector, it reflects the boom in technology stocks. Some pundits are drawing parallels with the nineties, arguing that the market may actually be in a bubble.

For energy, however, it is a bit more baffling, markets are clearly pricing a high probability for recession (the negative ranking of materials and industrials clearly show this) but oil prices do not seem to reflect this! Pressure from proponents of peak oil and the continued strength of emerging market economies may go some way to explain this, but who knows? Sentiment can sometimes be finicky.

Rebalancing vs. Buy & Hold

In these tumultuous times, one wonders what sort of investment strategy to adopt. The modern portfolio theory rule of thumb would be to "stick to one's guns" by remaining thoroughly diversified and keeping a disciplined approach to rebalancing the portfolio when asset class weights deviate "too far away" from a defined optimal value.

Rebalancing can actually be tricky in times of high volatility not only because it may require quick action to counter large sways in the market but also because of the additional transaction costs that frequent "adjustment" trading could entail.

There is, however, an optimal level of rebalancing that can be implemented, depending on market volatility conditions. Studies show, for example, that rebalancing (adjusted for transaction costs) outperforms buy and hold strategies in periods of high volatility where markets experience sharp reversals. The opposite occurs in bull or bear market conditions, where the markets follow a clear trend. In this environment, buy and hold strategies tend to outperform rebalancing.

An optimal portfolio allocation strategy would therefore be one that is a function of the volatility levels of the markets. When volatility levels spike, as they have over the last couple of weeks, it would trigger a rebalancing signal for the portfolio. This could be in the form of a tightening of the rebalancing band limits of the respective asset classes. In contrast, when volatility levels are subdued, those same band limits should widen, reducing the probability of rebalancing but not eliminating them altogether, which would be risky, especially in transition periods from low volatility to high volatility.

A double dip?

According to the latest remarks from the Fed, the stimulative policy that began soon after the sub-prime crisis began in 2007 is likely to remain for some time to come. If we read between the lines, this would basically mean that the Fed is becoming increasingly pessimistic on the growth prospects of the economy and rightly so, considering the growing deficits that the U.S. and Europe are facing. In fact, as we have been saying since the end of 2008, this crisis is likely to remain with us for at least another couple of years. There is no quick way out of it, unless a very aggressive form of "financial repression" combined with hard core austerity is forcibly implemented, but if the U.K. riots are any sign of how ugly things can get, there doesnt seem to be much that can be done in the short run.
Market sentiment in this environment has become risk averse to such a degree that even treasuries, that recently lost their triple-A rating, have actually been rallying. This would be the second time in four years that "pundits" have gotten the direction of interest rates seriously wrong.
In summary we should be embracing ourselves for a global "double dip" as the U.S. increasingly embarks into what looks like an austerity program in disguise!

A revised Big Mac Index...

One fascinating index that has gained in popularity through the years is the Big Mac Index that is published by the Economist newspaper. It is interesting because it provides a very different approach to measuring the over or under valuation of exchange rates, based on the Purchasing Power Parity (PPP) theory which states that in the long run, the exchange rates between countries should adjust themselves to bring about parity in prices.
As the "Big Mac" is a commodity that is readily available in most parts of the world and because its price is very easy to obtain prices, it is very suitable for making cross comparisons.
One large drawback with the measure, however, has been that it does not adjust for differences in productivity which means that for emerging markets with cheaper labor, it will tend to introduce an underweighting bias to the figures. This bias is confirmed by a simple regression of the price of a Big Mac to GDP per capita. There is a clear positive correlation between the two.
In order to account for this, the Economist recalculated its figures by adjusting for differences in productivity. The end results are very different from the original calculations. China, for example, which was thought to have a currency that was undervalued to the dollar, according to the original figures, now finds itself slightly overvalued with the new calculations! It is also interesting to note the substantial overvaluation of the Brazilian Real and the continued overvaluation of both the Swiss Franc and the Euro.
In these times of growing uncertainty and rumors that official CPI figures may be rigged, the Big Mac index provides a more reliable measure of the PPP adjusted currency exchanges.

Playing with fire...

...describes well the dangerous games of partisan politics in the U.S.

Postponing a deal on the debt ceiling which is scheduled to expire in the beginning of August to the last minute is akin to playing with fire not because they will not strike a deal before the set deadline (they most likely will) but because the markets are right now at arms length of entering panic mode as tensions continue to build up. Our June newsletter outlines the so called "clear and present dangers" that are on the sidelines, waiting for that as yet unidentified catalyst that could trigger another dreaded crisis on the markets.

It should be noted that the U.S. debt debacle is taking place on the backdrop of a clearly worsening debt crisis in Europe, which is now showing signs of spreading to the bigger peripheral country economies of Italy and Spain. The reason why investors have become so jittery is because both Spain and Italy happen to be just too big to rescue.

Although stock market volatility rates remain subdued there is a clear "flight to quality" momentum that is building up as gold, the Swiss Franc and government bonds of countries perceived to be less affected by the debt debacle break records.

So what is one to do when the threat levels are just one notch before panic mode? Well, for one you should stick to the old adage of ensuring a sufficient degree of diversification. But you also run the risk of losing more through diversification if things suddenly improve. That is because the probability that things are going to get worse currently have a greater weight in the market pricing of assets than the probability that things will improve, so if things do improve and you are diversified into investments that are meant to protect the portfolio in bad times, those are the ones that will suffer the most. It is always easier to construct a portfolio in stable rather than unstable market conditions because the risk premium component of the value of an asset will be a smaller percentage of the total. So there is a timing element to diversification but that should matter less over the longer term.

On the horns of a dilemma...

At each cry of help, the powers that be are injecting a potent but short lived dose of life sustaining matter into the system, but this is unfortunately just another case of too little too late. The political setup of this European "experiment" is their "Achilles heel" that impedes them from doing what is needed to avoid a train wreck. With the record erosion of the Euro against the Swiss franc and European stock markets now firmly in negative territory there is little that can be done to stop contagion from spreading. Default is still in the cards but the more time passes the less likely that it can be conducted in an orderly manner.
Mind you, the U.S. is in its own mess too, still recovering from a colossal debt burden and no way out of it, other than to print more money to buy more time. Still, the fact that the U.S. enjoys both economic and political integration puts it at a major advantage to Europe, and right about now, the markets seem to agree with this.

Distrust with a slump...

The steady rise in the value of gold to a large extent reflects the eroding trust in the monetary authorities of the world, most notably those of the U.S. and Europe. Commodity prices have been following the same pattern until very recently. The price of oil, for example, has been surging on the back of speculation related to a potential constraint on the supply side, reflecting the ongoing conflicts in the Middle East. This speculation has also appeared on the demand side, reflecting the anticipation of more demand from emerging markets and, at a more distant future, greater demand from developed markets as their respective economies recover.

More recently, the price of oil has seen a sharp drop in value reflecting the economic turmoil that is brewing across Europe and the U.S. In the speculators mind, two things have changed on the demand side of the equation. Emerging markets, battling a surge in inflation are applying the monetary brakes more aggressively whilst the economic conundrum in Europe and the U.S. that seems to be showing signs of worsening is likely to postpone any sustainable recovery to a more distant future.

In summary, what these two indicators are telling us at this point in time is that the distrust in monetary authorities continues but that the global recovery is in peril.