This past week saw weakness in stocks mostly driven by realizations that both the European economy and Chinese economy are both slowing down. The embarrassing story of the week was the attempt to take BATS Global Markets (headquarters in Lenexa, KS) into an initial public offering (IPO). BATS, which stands for Better Alternative Trading System, runs two exchanges that collectively rank third in terms of U.S. share trading, behind the New York Stock Exchange and Nasdaq. The story with the attempted IPO of BATS is that the IPO was supposed to happen on the actual BATS exchange itself. But, a technical glitch (technical glitch on an electronic exchange) saw the shares of BATS selling at pennies versus the intended opening price of $6 per share. The sad part of this story for investors is that electronic trading makes up 70% of all trading, and this exchange could not even get their own IPO correct.

Tough Decisions
Investment advisors face tough decisions on a regular basis. The occurrences of tough decisions have gone up by a factor of at least three since 2008. The increase in tough decisions is a direct result of the changes in what is risky and the change in old investment axioms. As well, the markets are no longer driven as much by fundamentals but more so by central bank policies.

Take a look at the chart below which is the S&P 500 over the last 20 years. Now, consider the history you see in the chart and the current economic environment. What might be the long-term upside potential, and what might be the long-term downside potential?

We can easily see the two big humps which have similar peak points and similar trough points. Also, take note of the formation of the windward side of the third hump that began in 2009. Lastly, take note of the little humps after 2009 that correspond with QE1 and its trail off, QE2 and its trail off, and now ‘Operation Twist’ which will be ending in June 2012. The money printing trail offs have all been in the spring, with languishing summers, only to be met in the fall with more money printing. Since the market is now driven by central planners (Federal Reserve and European Central Bank), we have to follow their path.

It is important to be aware that the larger run up in the market, from the early 90s until the dotcom top, was underpinned by a much healthier global economy than we have today. It is also important to be aware that the run up in the market from 2003-2008 was underpinned by low interest rates and easy money like we have today! If we follow the path of information and facts, we now have a less healthy global economy with the western world heavily indebted, massive de-leveraging from the decades long credit boom, an ongoing currency/trade war, China growth slowing, and Europe teetering on the edge. In addition, we currently have global easy money reflating the stock market once again. Still, I do not think the powers that be are ready to let the market rollover for a long leg down just yet. Short and long-term outlooks follow.

Short-term Outlook

The Fed is now having to fight rising oil prices and rising interest rates. The only way the Fed can push down interest rates is to buy bonds, which equals money printing, which weakens the dollar. The dollar typically runs opposite of oil and stocks. So, by pushing down rates (weakening the dollar), the Fed may just push up oil prices, which could drive stocks. There is a point where rising oil and rising stocks must end due to oil’s impact on the economy. Rising oil prices and much of the economic data coming in (other than massaged jobs data) has been weaker than expected. Actually, of the last 14 data points released on the economy, 12 of the 14 were weaker than expected.

Now, consider the stock market is in overbought territory and interest rates are rising. What could help the Fed? Temporary weakness in the stock market can play nicely into the current interest rate and oil conundrum. A falling stock market will push investors to buy bonds (saving the Fed from having to do so for now), which brings down interest rates. A falling stock market will drive up the dollar, which will drive down oil prices. A falling stock market will cause Wall Street to start asking for more money printing. More money printing is well received by Wall Street, and the stock markets react positively. Wash, rinse, repeat. This cycle is what we have been seeing in the last few years.

What is an investor (or advisor) to do? The prudent, fiduciary part of me says to stay conservative and not over commit to the market right now. We will certainly see better stock buying opportunities than we have today in the short-term. The better opportunities could come in the form of a modest pullback in the short-term, which could lead to a fair size pullback like we saw last summer after QE2 ended. This market is long in the tooth and will pull back. The next pullback will offer a short to medium term buying opportunity. The next pullback is the point that I will add more equities to portfolios to catch the next money printing cycle up.

So, in the short-term, we wait for a pullback to catch the next ride up. The changes coming to portfolios during and after the next pullback will be to greatly reduce bond exposure as their long, bullish market cycle comes to an end, and increase stock holdings that will weather a slow growth, inflationary environment. In addition, I will be lowering cash exposure in favor of investments that offer better purchasing power preservation.

Longer-term Outlook

We are currently about 11% away from the all-time top on the S&P 500, and 51% away from the recent bottom. This tells me that there is more long-term downside than long-term upside left at this point. If we do see some pullback in the market in the short-term, it will offer a buying opportunity for the next leg up. This next leg up may be the one we have to watch closely as it could put the market near an all-time top on a very slippery slope.

When we get close to tops, we have to remember history when everyone else will have forgotten it. Let’s recall 1999 and 2008 where the stock markets had already registered a number of years of gains. Some advisors and investors turned cautious on the market in 1999 and 2008 as the fundamentals (declining) grew further out of whack with the market (rising). For advisors that understood the party was not going to last, they could have either stayed in the market and risk getting crushed by a correction, or begin stepping out of the market and possibly have clients revolt for not performing in line with the high-risk, stock indexes that do not recognize outlier risk.

In hindsight, how many investors would have been happy to have stepped down their stock exposure somewhere in 1999 or 2008 even though in the moment it would have seemed foolish as the market rose a little further? Sure, they would have given up some potential gains, but the drops they would be missing were just around the corner. Standing ready to be defensive will get more important the further this market climbs. I believe the need to be defensive now (and more so in the future) is important because if the next leg down happens in this environment, the recovery period will be long. It will be long since the tools to lift the market will have been spent already (zero interest rates, and tons of money printing and investors not willing to commit to stocks). Chance favors the prepared mind.

Do you have an investment strategy that seeks to protect your portfolio against volatile economic conditions?  Call me to schedule a free review of your current investment portfolio – 913.402.6099.

John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals.  For more information, visit https://www.chladekwealth.com.

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