The Summer Winds

Gale force winds are now blowing in from across the sea for both the U.S. economy and investment markets.  After starting off the year strongly in 2012 Q1, the stock market is down over -9% thus far in the second quarter and has nearly surrendered all of its year to date gains.  The sharp pullback is being driven by several factors.

First, the already sluggish U.S. economy is showing mounting signs of weakening back toward recession.  Economic growth has been slower than expected in recent quarters and a variety of indicators have been falling short of expectations in recent months.  Friday’s employment report was just the latest example, as the U.S. economy added only +69,000 net jobs in May, which fell well short of consensus expectations.

Also, the Chinese economy is also showing signs of deterioration.  Economic activity has been decelerating for some time as both domestic and international demand continues to fade and inventory levels are rising.  This growth deterioration is already having ripple effects across Asia as well as in the United States and Europe.

Lastly and perhaps most significantly, the debt crisis in Europe continues to descend toward full blown crisis.  A variety of countries that share the euro currency including Greece, Portugal, Spain, Italy and even France are buckling under the weight of the rising cost to refinance their own debt.  And some are unable to access credit markets whatsoever.  The problems in the Euro Zone may soon be approaching a critical flashpoint when Greece holds elections on June 17.  The current Greek government supports the required austerity measures to continue to receive rescue funds from the European Union.  But if the upstart Syriza party prevails in the upcoming election, it is widely believed that they will reject the austerity program, which may ultimately lead to Greece’s exit from the euro currency.  Such an event has a high probability of sparking a financial crisis both in Europe and around the world.

The impact of these forces highlights the advantage of broad asset class diversification beyond the stock market.  While the above forces have placed meaningful downside pressure on the stock market, they have provided equally meaningful upside support to other categories.  These include U.S. Treasuries and TIPS, Agency Mortgage Backed Securities, Municipal Bonds and the Japanese Yen currency.  And although precious metals such as Gold and Silver have recently lagged, they also stand to benefit substantially from the developing economic backdrop.

Market activity on Friday highlighted the benefit of this broad portfolio diversification.  Friday was by far the worst day of the year for the stock market with the S&P 500 declining by over 32 points or -2.5%.  But Friday was also among the best days of the year for a composite portfolio that includes all of the asset classes above, as Gold gained nearly +4%, Silver rose +2.5%, Long-Term U.S. Treasuries advanced by +2.4%, and other categories such as Build America Bonds, Municipal Bonds, U.S. TIPS, Agency MBS and the Japanese Yen all posted solid gains between +0.1% and +0.7%.  Thus, a composite portfolio containing all of these asset classes gained +0.5% or more on Friday when the stock market alone plunged -2.5% on the same day.

Looking ahead, June promises to be a critical month for investment markets.  In addition to the Greek elections on June 17, the latest U.S. Federal Reserve stimulus program in Operation Twist is set to expire at the end of the month.  And the stock market has performed poorly without the support of Fed stimulus in recent years.  As a result, the upcoming Fed meeting on June 19-20 will warrant particularly close attention for any suggestions about further stimulus programs in the coming months.

In terms of strategy, portfolio allocations to stocks had already been meaningfully reduced ahead of the current correction in favor of many of the other categories listed above.  And given the developing risks in the coming weeks, these stock allocations are likely to be reduced even further in the coming days in favor of more defensive positions that continue to perform consistently well.  With this being said, if the economic outlook and the stock market sell off continues to accelerate to the downside, I will be watching closely in the weeks and months ahead for opportunities reestablish a greater allocation to stocks with the expectation that global central banks including the Fed and the European Central Bank are likely to launch fresh new stimulus programs in response to the situation.  In the meantime, it is likely that portfolios will hold higher than normal allocations to cash, as such positioning provides the utmost safety during periods of unfolding crisis while providing the full flexibility to make tactical purchases following any major market sell offs.

 

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

 

Heinz

Defensive names like H.J. Heinz (HNZ) make a great deal of sense in the currently turbulent market environment.  While the stock market as measured by the S&P 500 is down nearly -7% since early April, Heinz is up over +4% over the same time period.  This is due to the fact that more defensive names like Heinz often outperform during this stage of the cycle as investors have greater confidence in the consistency of operating performance from a company that sells ketchup and beans versus other firms in the market.

Despite these advantages, the opportunity was taken to lock in gains and exit positions in Heinz on Friday (5/11/12) for the following reasons.

First, positions in Heinz were first established at the market lows last summer on August 9, 2011.  And it has generated strong results in the months since, having returned +15%. 

Second, defensive stocks like Heinz as well as those in the Consumer Staples, Health Care and Utilities are beginning to approach the later stages of their own leadership phase in the stock market.  Defensive stocks assumed market leadership back in March, and while they may continue to outperform on a relative basis during the summer, they may begin to struggle in their own right on an absolute basis if the broader market correction continues to accelerate.

Lastly, Heinz is currently trading at the top end of its range, suggesting now is a particularly good time to lock in gains.  In breaking out decisively above $54 per share to reach new highs, it is now overbought with an Relative Strength Index (RSI) over 70.  The last several instances Heinz approached or exceeded an RSI reading of 70, the stock subsequently corrected between -5% to -13%.

Looking ahead, Heinz continues to represent an ideal core holding for equity portfolios.  Thus, monitoring for potential reentry points on any meaningful pullback is worthwhile.  Ideal points to watch for consideration include the 200-day moving average (red line in chart above) and the 300-day moving average (green line).

Ultra Petroleum

One of the most attractive long-term investment themes is in the natural gas industry.  And Ultra Petroleum (UPL) represents one of the most fundamentally solid and attractively valued stocks in this space.  And while I remain as positive as ever on this long-term theme, I exited positions in UPL during today’s trading for the following reasons.

Short-term forces have had the natural gas thesis under pressure in recent months, as prices remain in secular decline due to oversupply more than offsetting the substitution effect from high oil prices.  This has caused the stock price of natural gas related companies like UPL to underperform.  While increasing substitution and a slowdown in production will eventually shift natural gas prices into a secular rise, we may still be at least a few months away at this point.  And with the global economy weakening and Europe descending toward potential crisis, now is not an attractive time to hold higher beta names like those found in the natural gas space.

 

The decision to exit Ultra Petroleum on Wednesday was driven by the following factors.  Since the beginning of the week, UPL has posted a +17% gain that included a +7.2% advance on Wednesday alone.  And today’s jump came on trading volume that was three times the average daily volume.  Given that short interest in UPL was running in the low double digits heading into the week, the recent sharp advance has the feel of a short squeeze.  This, of course, is not the foundation for a sustained move higher.  Another factor driving the UPL sale was technical resistance.  During the trading day, UPL advanced up to resistance at its 50-day moving average before quickly pulling back.  UPL has risen into resistance at its 50-day moving average on six separate occasions over the past year, and on each past instance it has failed and moved lower.  These factors along with the Relative Strength Index reaching a bearish peak reading at 50 all suggested that the timing was right to step to the sidelines on this position.

I will likely look to reestablish positions in UPL at some point in the future when fundamentals start to show signs of sustainable improvement and the technical picture is more constructive.

One Step Closer To The Edge

We arrived at vital inflection point for investment markets this past weekend.  On Sunday, voters took to the polls in France and Greece and swept new political leadership into power.  This outcome was particularly important for the following reason.  For the first time since the outbreak of the financial crisis, the people have replaced key political leadership supporting austerity and bailouts with those that have an explicit mandate to reject the status quo.

The change may ultimately mark the beginning of the end for the ongoing crisis.  Of course, the path to the end will take time and is likely to be accompanied by periods of extreme turbulence along the way.

Overall, the election results from the past weekend are signaling an increasing general public fatigue with the problems that continue to overhang the global economy.  People either don’t want to face the problem any more (France), or they just want to take the pain and get on with it (Greece).  While renewed deficit spending in France might provide a near-term boost to growth, it also has the dire potential to eventually send French debt costs spiraling and crush their economy.  But the more critical implications are associated with Greece, as the path may now be set for the country to depart from the euro currency.  This has the potential for a variety of chaotic aftershocks.

The European elections have occurred at a critical time for U.S. markets.  At the end of June, the U.S. Federal Reserve’s latest stimulus program known as Operation Twist is set to expire.  This is important because Fed stimulus programs since the beginning of the financial crisis have artificially inflated both the stock and bond markets in a significant way.  And just as staggering stock market declines occurred almost immediately following the end of these past stimulus programs, stocks are primed for another sharp correction once again in the coming months (the outlook for the bond market is mixed due to opposing forces at work).

For these reasons and more, it promises to be another interesting summer for investment markets.  This backdrop has important implications for portfolio strategy and asset allocation.  As a result, a gradual tactical shift in allocations is likely to occur over the coming weeks as we move into the summer.

Fortunately, a variety of strong investment prospects continue to exist in such market environments.  In addition, particularly attractive opportunities can present themselves during periods of market turbulence.

With this perspective in mind, selected core positions are likely to remain in tact.  Others allocations are likely to be more opportunistically traded going forward.  Lastly, a potentially sizable cash and/or cash equivalent positions may be raised at selected points in time.  This may be done in an effort to sidestep periods of heightened volatility while also standing ready to purchase assets that may become extremely oversold during short-term market liquidations.  I have already been in the process of raising cash since the beginning of the second quarter, and this may continue depending on how market conditions unfold in the weeks ahead.

In the coming days and weeks, I will be making regular blog posts detailing portfolio changes and latest portfolio allocation strategies and perspectives.  For those that would rather not visit the blog, I will be sending periodic e-mails (most likely on a weekly basis) to current clients designed to summarize the content of these blog posts.  I will also be posting additional detailed analysis in articles on Seeking Alpha.

In the meantime, the following are the categories that make up the GWM composite asset allocation at the present time.  While each client account is managed with specific objectives and circumstances in mind, listing these categories is designed to provide the general framework of my latest perspectives on investment markets.  I have provided a brief note on each position and will provide more detailed explanations of each in upcoming blog posts.  And as events unfold in the coming months, I will also announce any changes to this category framework along the way.

Agency Mortgage-Backed Securities (MBS) – Focus of future Fed stimulus programs
U.S. Treasury Inflation Protected Securities (TIPS) – Defensive inflation protection
Long-Term U.S. Treasuries – Stock market hedge, yield
Municipal Bonds & Build America Bonds – Stock market hedge, yield
Gold & Silver – Hard asset protection against crisis, stimulus and inflation/deflation
Tactical – Includes positions held opportunistically as select situations present themselves in stocks, preferred stocks, high yield, real estate, commodities, bonds, currencies, volatility and cash

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

The Tootsie Roll Trade

Tootsie Roll is a company that often flies below the radar.  It has a closely held stock with a market cap of just $1.3 billion and an eponymous product whose recipe has not changed in over a century.  Overall, it is a small and steadily growing company that is not known to steal the headlines very often.

But since October 2011, it has presented an increasing investment opportunity.  Here’s why.  Over time, Tootsie Roll stock has closely tracked the performance of the broader stock market as measured by the S&P 500 Index.  The one key difference was that during periods sharp stock market correction, Tootsie Roll would typically hold up better than the market due to the defensive characteristics of its candy business.  Since late last year, however, shares of Tootsie Roll have stalled while the stock market has rallied sharply higher.

This sudden divergence has set up opportunity with Tootsie Roll shares, as one of two outcomes are likely to happen going forward.  Tootsie Roll shares will either rise to catch up with the stock market and resume its historical correlation, which implies attractive potential upside, or the stock market will correct lower toward levels where Tootsie Roll is currently traded, which implies greater downside protection than the overall market.  For these reasons, Tootsie Roll represents an attractive risk-adjusted stock investment opportunity in the current market environment.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

GWM Commentary: 2012 Q2 Outlook – Market Distortions & Policy Contortions

These remain most interesting times.  A well-established interrelationship has historically existed between the economy and the various asset classes that make up investment markets.  But over the last several years since the outbreak of the financial crisis, this traditional harmony has fallen into discord.  Why has this occurred?  It is largely due to the persistently massive monetary policy interventions by the U.S. Federal Reserve (the Fed) and global central banks.  And these policy contortions are likely to lead to continued market distortions as we move through the second quarter and the rest of the year.

The current economic outlook remains deeply challenged to say the least.  Optimism about an economic recovery in the U.S. has started to predictably wane in recent months.  Although data toward the end of last year was hinting at improvement, it was largely driven by the effects of businesses pulling spending forward into 2011 in order to take advantage of the accelerated depreciation fiscal stimulus program before it expired at the end of last year.  But with this program now over, economic readings are once again on the fade as we slowly move toward a fiscal cliff at the end of the 2012.  And the U.S. is not alone in its challenges, as growth is slowing across Asia and Europe has officially entered into recession while still battling against full-blown crisis.

The events of the first quarter highlight the distorting impact that monetary stimulus from global central banks has had on investment markets.  A market environment defined by prudence and caution typically accompanies periods of economic deceleration and uncertainty such as today.  This includes a stock market that is at best choppy if not in decline, as investors migrate away to the relative safety of more defensive asset classes.  But since late last year, we have instead seen a market exhibiting near euphoric optimism that has included a stock market rising with little pause.  This unusual outcome can almost exclusively be attributed to monetary policy actions by global central banks including the Fed and the European Central Bank (ECB), both of which have been fully engaged in stimulus activity since last October.

Markets driven primarily by monetary policy are prone to extreme risks.  Put simply, when the Fed is stimulating, the stock market typically rises.  But once the Fed stops applying stimulus, stocks almost immediately begin spiraling sharply lower.  This is due to the fact that a stimulus driven market is not rising based on sustainable fundamentals.  Instead, it is floating higher on monetary adrenaline to levels that the current economy simply cannot support.  And once this adrenaline is removed, stocks immediately begin moving to find their true fair value, which unfortunately is much lower than where the market is currently trading.  This helps explain why the stock market fell so swiftly starting in April 2010 and July 2011, as both of these episodes began exactly two weeks after the end of the Fed’s last two stimulus programs.

Thus, the future direction of the stock market will be highly dependent on Fed policy.  The current Fed stimulus program known as Operation Twist is scheduled to end in June 2012. This fact alone will greatly impact the stock market outlook both for the second quarter and the rest of the year.  Given that the stock market has already risen sharply in recent months and the ECB has now completed it scheduled Long-Term Financing Operations (LTRO) it is likely that we could see the stock market grind back and forth for much of Q2 just as it did last year before the end of QE2 back in June 2011.  But if the Fed allows Operation Twist to conclude without any additional stimulus planned, a sharp stock market correction starting in mid to late July would be likely.  However, it is possible that the Fed might seek to launch a new stimulus program (“QE3” or “Operation Twist 2”) at the beginning of July.  This has the potential to sustain stocks at current levels if not provide an additional boost to the upside in the second half of the year.  For these reasons, monitoring the Fed’s words about its next policy movements if any will be particularly important as we move through the second quarter.

It should be noted that the Fed is facing some critical challenges in trying to apply any further stimulus going forward.  First, the stock market has not been the only thing that has been lifted by Fed stimulus, as oil and gasoline prices have also been propelled higher even more so than stocks.  If the Fed opts for additional stimulus, they risk increasingly crushing the economy under the growing inflationary weight of rising energy costs and gas prices at the pump.  Second, the threat of crisis in Europe continues to mount, with problems increasingly impacting major economies such as Spain and Italy.  Even if the Fed continues to pour on stimulus, the problem in Europe may soon overwhelm the Fed’s efforts.  Lastly, the Fed faces a potentially tricky situation politically in the second half of 2012 due to the Presidential election.  Historically, the Fed has sought to step aside from policy action during the election season, so any policy actions they do or do not undertake will likely face close inspection in the coming months.  All of these are factors that also warrant close attention going forward.

Current portfolio strategy continues to emphasize navigating these policy and market risks in the months ahead.  A continued allocation to the stock market is warranted given the continued monetary adrenaline scheduled for the coming months.  But given the policy toxicity that is impacting the market, it remains prudent to keep these exposures to weights that are proportional to other asset classes.  Moreover, specific stock positions remain focused on the more defensive areas of the market including Consumer Staples and Utilities.  Not only are these names more likely to hold up better during any market pullback, but they have also underperformed notably in recent months and are overdue to move back in line with the overall market if it continues to rally.

Of course, the stock market is just one of many asset classes available in the market today.  And in terms of these various other categories, the priority remains on selecting those asset class that have shown the propensity to rise regardless of the events impacting the stock market and applying them in a portfolio construct that balances risk with long-term upside potential.  These include U.S. Treasuries and TIPS, Agency MBS, Municipal Bonds, Corporate and High Yield Bonds, Precious Metals such as Gold and Silver, selected Real Estate, selected Currencies, Cash and Cash Equivalents, and Volatility.  At present, this includes strategies that are only 40% positively correlated to the stock market, with another 45% uncorrelated and the remaining 15% negatively correlated.  This also includes striking a balance between inflationary risks (if the economy recovers) and deflationary risks (if the economy falls into recession).  Given the current economy, this includes a 40% weight to inflationary assets, a 40% weight to deflationary positions and the remaining 20% to price neutral allocations.

As discussed in my recent announcement on the new GWM communications platform, I will be following up this Q2 outlook over the coming weeks with additional posts providing detail on the various portfolio positions discussed above and the underlying strategy and expected time horizon associated with each.

The Potential Implications of The Greek Default

What has been expected for months became official on Friday.  Greece has now officially defaulted on its debt.  This raises the important question of what can we now expect from investment markets.  Initially, the response is likely to be minimal, as policy makers have been preparing for months for a Greek credit event.  This has included flooding the European banking system with liquidity and helping to orchestrate Thursday’s PSI deal to come together as planned.  Today’s trading in stocks, bonds and commodities were evidence of the muted initial reaction. 

Of course, it is never what is anticipated that shocks the market.  Instead, any market fallout will likely result from unexpected spillover effects from the default and would likely only begin to surface sometime out over the next few weeks.  A prime candidate for trouble would be the settlement of the CDS contracts written as insurance for the Greek debt.  If a financial institution that wrote the CDS insurance is unable to make payment on the claims (the circumstances that took AIG under back in 2008), this could potentially spark a contagion effect.  But sustained problems with CDS is also unlikely in the end, as the European Central Bank has gone to great lengths to try and protect banking institutions from this type of outcome and would likely quickly intervene with additional support if necessary.  Perhaps we will see some small market shocks along the way, but it does not appear at least at this juncture that anything material is likely to come from these settlements.

Instead, the real danger from the Greek default likely still lurks in the shadows.  And it would ultimately be something that policy makers are not currently seeing or monitoring.  And rather than it being associated with Greece, the actual threat most likely resides with one of the several other struggling nations in the Euro Zone.  Portugal is the first name that comes to mind in this regard, but Spain may ultimately be the prime target in the end that could potentially unravel the markets.  And if this were to occur, it is likely that it would take several months to unfold.

Hopefully such contagion effects can be contained and we can begin to move past the situation in Europe.  In the end, this will require policy makers in the region to take more clear and decisive action than they have taken to this point.

I plan on writing a more detailed article for Seeking Alpha on this topic over the weekend.  I will post a link to the article here if and when it is published, most likely on Sunday.

Thanks and enjoy the weekend.

Bad Signs For The Greece PSI

Greece is currently trying to complete a $270 billion debt restructuring, which is a required step in securing the next round of bailout funds from European Central Bank.  The deadline to complete this restructuring is Thursday.  While the stock market had been assuming all along that Greece would get the deal done, doubts are clearly now emerging that we may see at minimum a delay or perhaps worse a default.  For a stock market that has been so universally sanguine thus far in 2012, the magnitude of today’s decline suggests that real trouble is now brewing with this deal.  And if a default were the outcome, we would likely be marking a turning point for stocks in 2012.  Stay tuned.

New Communications Strategy

I am writing to announce a new communications program for Gerring Wealth Management that I am launching today.  The focus of this new program is to provide more real time investment market perspective and portfolio strategy information on a regular basis.

The new program consists of the following:

GWM Commentary Blog
The Gerring Wealth Management website has been redesigned for more timely communications.  My updated website can be found at the link below:

www.gerringwm.com

As part of the redesign, the front page of the website is now a blog.  I will be regularly posting (3-5 times per week on average) short and concise contributions (typically 400 to 800 words) on topics ranging from economic/market perspectives, portfolio specific investment strategy information and administrative updates.  This information will be made available to you in one of three ways.

Follow via e-mail: You can enroll to receive e-mail updates when a new blog entry has been posted by entering your e-mail address in the “Follow Blog via E-mail” box on the upper right side of the webpage.  Your enrollment in the blog as well as your e-mail address will not be shared and will be kept private.

Visit at your convenience:  You can visit www.gerringwm.com at any time to see latest news and updates

Traditional e-mail delivery:  In keeping with the past process, I will send out periodic GWM Commentary e-mails that will aggregate the information that has been posted on the blog.  These e-mails would likely be delivered every one to two weeks depending on conditions driving the market.

Seeking Alpha
I am a regular contributor for Seeking Alpha, which is a website where investment professionals write articles on economic/market perspectives and portfolio strategies.  I know some have already found my articles on Seeking Alpha, and the new communications program is designed to better coordinate these articles with the GWM specific communications strategy.  My page at Seeking Alpha can be found at the link below:

http://seekingalpha.com/author/eric-parnell/articles

If interested, you can follow me directly at Seeking Alpha.  I will also be posting updates to the GWM blog when I have a new article posted at Seeking Alpha.

Individual Communcation
As always, I will continue to contact you individually over e-mail or by phone with periodic updates and as needed over time as events unfold and portfolio circumstances require.

My objective with this new communications program is that you can access as much or as little information about investment markets and how it specifically relates to your portfolio at any given point in time.   The GWM Commentary Blog will also provide a broadcast platform in the event of another market crisis event.

If you have any questions on this new communications program, please give me a call or send me an e-mail at any time.

Thanks and I hope you find this new communications strategy useful and worthwhile.

Eric Parnell
Gerring Wealth Management

The Greek Paradox

A default by Greece is inevitable.  It is not a matter of if, but when.  And it appears that this final outcome may now be drawing near.

The problem for Greece all along has never changed.  Greece borrowed too much money.  Now they can’t pay it back.  In order to receive help from its European neighbors in the hope to eventually pay back these loans in the future, it is being required to raise taxes and cut government spending.  But both of these policy actions will cause growth in the Greek economy to slow even more, which further reduces their ability to pay back these loans.  In short, the problems only become worse over time, not better.

Yet policy makers have insisted on preventing Greece from defaulting for the last several years now.  Why?  Because a Greek default threatens to create a domino effect that could result in another global financial crisis.  This is due to the fact that many banks across Europe hold Greek bonds.  If these bonds become worthless, many of these banks may subsequently fail themselves.  And the Lehman scenario from late 2008 starts to unfold all over again.

The next key debt refinancing deadline for Greece is quickly approaching on March 20.  Negotiations have been ongoing for months now to ensure that Greece receives the latest round of bailout funds from Europe.  But as we draw closer to the breaking point for getting something done, the posture of European policy makers appears to be changing.  While Greek leaders continue to push feverishly with newly approved austerity promises, European leaders are responding with greater skepticism and complacency.  Given the urgency of the situation, this more relaxed stance suggests European policy makers are becoming increasingly resigned to the fact that Greece simply cannot be saved.  And instead of throwing more money at a situation that cannot be solved, perhaps it is time to just get on with it already and see what happens.

In many respects, global policy makers have been preparing for months behind the scenes for a Greek default.  Their focus has been setting up support for the banking system.  Back in late November, global central banks coordinated to opened up currency swap lines to ensure that at risk banks have adequate liquidity access.  Then in December, the European Central Bank (ECB) made collateralized loans for 3-years at 1% with virtually no strings attached to banks across the region that needed the funds.  And the ECB is set to do offer another round of loans at the end of February just in case any banks need to be topped off with liquidity and balance sheet support.  All the while, global central banks from around the world including the U.S. Federal Reserve continue their own aggressive monetary stimulus programs.  These are just some of the actions that have occurred recently that have the look and feel of a world that is getting ready for a potential shock.  Fully liquefy the system in advance, stand ready to act once the event strikes and hope for the best going forward.

The stock market has thus far been remarkably complacent in the face of this risk, rising seemingly every day and often without much of a reason.  This phenomenon, however, is also due to the ongoing distorting effects of monetary stimulus on stocks.  Put simply, the stock market becomes artificially inflated when liquidity is being injected into the financial system.  But the problem with this distortion is that the stock market quickly collapses once this artificial support is removed.  This was why the stock market corrected so sharply starting in late April 2010 and again in late July 2011.  In both instances, stocks were detoxing from the withdrawal of monetary stimulus.

At present, the stock market is once again elevating behind the influence of monetary stimulus, but this may not last for much longer.  This is due not only because stocks are now vastly overbought, but also due to the fact that stocks have shown the increasing tendency over the last year to decline swiftly and sharply even when they are still receiving the support of monetary stimulus.  Last year around this time it was Libya, Egypt, rising oil prices and the Japanese earthquake that sent stocks for a ride lower over several pullbacks in the spring.  This year, the unfolding situation in Greece may be the catalyst to spark the latest sell off.

So what can we reasonably expect from investment markets in the event that Greece actually goes into default in the coming weeks?  The answer here is far more nuanced than might be expected.

If Greece defaults, the initial stock market reaction is likely to be fairly muted.  An immediate sell off followed by an equally quick recovery is a very likely possibility.  It would not be surprising after the immediate reaction to even see stocks gradually rise in the subsequent week or two.  This is due to the fact that the financial system is prepared for a Greek default.  This is the event that everyone is watching and anticipating.  And it is directly around the Greece situation where all of the monetary levees have been placed.

Instead, it is in the aftermath of the Greek default where the true danger lies.  This is due to the fact that when a major market dislocation like a Greek default occurs, the spark for contagion typically arises from unexpected sources in the end.  When Lehman failed back in 2008, stocks did not collapse immediately.  Although they thrashed about in the initial days, it took three weeks before they started to fully cascade lower.  When Credit Anstalt failed back in 1931 during the Great Depression, the stock market sliced back and forth for over a month before falling off a cliff.  In both cases, this delay was due to the fact that the problems that eventually pushed the stock market lower emerged from sources well removed from what was perceived by policy makers to be the primary areas of concern.  And given the magnitude and complexity of the current crisis in Europe, there is no reason to expect anything different this time around with Greece.  Stocks may not go down immediately, but they may eventually get pulled sharply lower once the true fallout effects eventually start to surface.

Fortunately, the market is made up of a variety of asset classes outside of the stock market, and each will have its own unique response to a Greek default if it were to occur.  U.S. Treasuries would likely rally strongly as investors seek a safe haven from the crisis.  U.S. TIPS, Agency Mortgage Backed Securities (MBS) and Utilities Preferred Stocks would also likely rise under the same influence, albeit at a more measured pace than nominal U.S. Treasuries.  Precious metals such as Gold and Silver also provide a degree of portfolio protection.  If history is any guide, they would likely rally immediately on the default announcement, pullback sharply once the mass liquidation activity gets underway, and then rally even more sharply once global central banks intervene with even more aggressive monetary support in an attempt to address any fallout.

Of course, European policy makers may eventually relent in the end and postpone the inevitable Greek default to yet another day.  This is the reason to maintain stock exposures in the face of such risks even with a stock market that is already overbought.  For as long as global policy makers continue to pour more money into the financial system, stocks have the potential to continue rising far beyond reasonable expectations until the policy support is finally removed or the next crisis flashpoint (military action in the Middle East?) rises to the surface.  And just as the numerous categories outside of stocks provide support during a crisis event, most also stand to participate to varying degrees if stocks continue to move to the upside.

These remain interesting times.  And while 2011 was an eventful year, 2012 may be even more memorable when it’s all said and done.  It should be interesting to see how it all unfolds in the coming weeks.