Diagnosis of the Situation

The last week has been a baffling; markets made an about turn. I would say the day that made me stand up and believe there will be SHORT TERM volatility, possibly another 10 - 15% downside to equities, was on 28 June 2010. Let's look at various indicators:

Sentiments

In terms of sentiment, commodity currencies have surprisingly fallen on 28 June. The Vix shot up to 35 before falling back to 30 on Friday (2 July). Non-Investment Grade credit spreads rose to 822 before falling back to 803. So the signals are mixed. On one hand, in the very short term, equity markets seem to point south. On the other hand, they do not point to a very BIG downside, i.e. a bear market because they are not breaking new highs. The Vix is hitting a lower high, or specifically, breaking on the downside. The credit spread surprisingly failed to break May 25th's high.

Valuations.

Earnings risk premium of most Asian indices are pretty close to a buy trigger. They are somewhere in the "middle of nowhere". But they are definitely not a "sell". Even in the west, valuations are not telling us to sell, unlike in 1999 and 2007. Take the example of the S&P500. Their trailing PE is around 15x. This means a earnings yield of 6.7%. The 10-year UST is around 2.9%, making the earnings yield premium at 3.8%. It is not as attractive as in 2009 when the risk premium was a staggering 8.5%, but it definitely isn't as expensive as in 2007, when the risk premium was only 1%.

Economic outlook

What concerns me is the 10y UST falling below 3%. The 3mth UST is still low, manipulated by government's loose monetary policy. But the 10y UST is signalling very slow economic growth ahead, to the tune of perhaps 2% GDP growth. At that rate of growth, inflation is likely to be 0 or no more than 1%.

The non-farm payrolls disappointed. Housing starts fell 33%, albeit that was the first month after the expiry of tax credits. The entire EU suddenly decided to embark on austerity measures, which I think is the biggest policy mistake since Roosevelt tried to balance public spending during the Great Depression.

The European banking system seems to be freezing up, reminding us of the Great Financial Crisis of 2008. While ECB is lending freely, at low rates, the banks are not lending because they are preoccupied with repairing their balance sheets. The one way out perhaps is to implement another TARP plan for the European banks, which will cause the EURO to tumble and stock markets to shoot up.

In Asia, China's latest PMI indicates a soft landing. Wages are rising in China, exports are slowing. A few countries like India are grappling with higher inflation.

Putting it together

The risk of a double dip has heightened, but is still unlikely. One fund manager I spoke to put the risk of a double dip at 30%. A V-shaped recovery is pretty much non existent, at 10%. A long, U-shaped recovery is still the most probable at 60%.

This is a very turbulent period whereby governments worldwide is trying to cut spending, hoping the private sector will pick up the slack. It's a very fine balance.

I am an optimist at this point and believe we will avoid a dip. We are in the age of printing paper money, where governments can inflate out of debt. I believe stock markets are likely to fall more. But when investors realise that a double dip is unlikely to materialise, stocks will make a strong rebound, eventually reaching a new high. After all, with interest rates at ZERO, where else can they park their money? Certainly not investment grade bonds.

Meantime, corrections of up to 25% are possible in a bull trend. I have spoken to many of my friends to diversify further, not to flee from equities. From last week, I've spoken to many to reduce positions that are in profit and keep the rest. We can't always sell on strength. Sometimes, we have to sell on the way down. but if it's the latter, we should sell slowly because markets may bounce up anytime.

Ultimately, investors should increase their efforts to diversify their assets. A "Neutral" mode of 60% equities / 40% non-equities is the best model right now. You then have the flexibility to downgrade stocks further if the situation deteriorates and other strategies like Vix will prop up your portfolio. The drawdown will not be big. If things improve, you can still partake in the upside via your equities.

My next post will identify some investment opportunities.