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"Do Nothing!"

Submitted by Erico Matias Tavares via Sinclair & Co.,

What's an equity investor to do these days?

Weekly S&P500: Jan 2013 – Today

On the one hand, the weekly S&P500 chart is resiliently bullish. The arrow in the graph above shows the only instance where there was a material correction since early 2013, quickly rebounding after that. The trend is your friend and so far it has been positive.

If there's one area where central bank intervention has been unambiguously successful it’s the stock market. The ECB will soon join the party with its own quantitative easing program. In an environment characterized by commodities in a downtrend, zero interest rates and (incredibly) negative yields across several sovereign and even corporate bonds, where else can an investor get some pizazz?

On the other hand, there are some pretty serious risks lurking out there. Here’s a quick overview:

  • Global economic growth forecasts continue to be under pressure (further evidenced by copper prices consistently below $3/pound and weakness in crude oil prices);
  • Global carry trades undermined by a strong US Dollar, which according to some estimates has been used to fund $5-9 trillion of asset purchases outside of the US (that’s quite a lot), and also the Swiss Franc, where its dramatic appreciation a few weeks ago caught many funds off-guard;
  • The realization that the bailout plan for Greece is not working and the polarization of positions between the borrower and its creditors on what to do about it might force a major change in the existing Eurozone construct;
  • According to McKinsey, the global consultancy, total debt levels in China have jumped from 158% of GDP in 2007 to 282% as of 2Q'14 – higher than in many advanced economies, raising concerns about credit sustainability and the feasibility of another stimulus encore;
  • Several emerging markets, particularly in Eastern Europe, Turkey and South Africa, have accumulated substantial debts in foreign currency, and any further depreciation of their own currency might make those debt loads unsustainable;
  • The Middle East is now a breeding ground for terrorism, attracting fighters from core European countries, South and Southeast Asia; containing this threat may require a lot of sacrifice and cost, with potential repercussions back home;
  • The prospect of continued sanctions against Russia, accompanied by an escalation of the conflict in Ukraine, will likely disrupt trade, diplomacy and credit flows between all the parties involved;
  • Many banks are heavily exposed to emerging markets, particularly in Europe;
  • Option volatility (VIX), credit and breadth indicators are not confirming recent US equity highs;
  • US equity valuation multiples are sitting at levels which historically have correlated well with very low returns over the following 7-10 years.

So what to do here?

Well, unless you are a fund manager who is paid to be in the markets no matter what, here’s an interesting course of action to consider right now: do nothing!

If there is one thing credit indicators and the strong US Dollar are telling us right now, is that there is trouble brewing out there. So you don’t have to rush to buy crude oil or copper because you think it’s cheap (although there’s some logic to that); you don’t have to buy equities because everyone else is doing it; you don’t need to be a hero to be a good investor (unless adrenaline is what you truly seek).

Of course we could move higher from here, much higher in fact. But there are times when holding a healthy amount of cash is not a bad option (provided it is kept in a safe place); actually, if the forces of deflation prevail this is the place to be.

It is important to note that after trillions in quantitative easing around the world these deflationary forces remain so prevalent, especially when there is a lull in central bank action. Perhaps policymakers should also consider the “do nothing” approach, let market forces clean out some of the excesses and reengage with the markets at levels where their programs can be much more effective. This may require a more pragmatic approach to central banking.

Indeed, this seems like a sensible strategy overall:

If you are in the major equity markets, you can protect your paper profits by tightening your stops and/or taking some chips off the table. Think about this one. When you buy at a (true) bottom, by definition the odds of gains are much higher than losses at that stage. But as prices move higher, at some point your expected gains will be much less than the accumulated profits you are now risking by remaining invested in the market. What's the risk/return profile of equities right now? That's a really good question.

Otherwise, you can always take a step back, keep your powder dry and wait for a major correction (there will always be one) or for key economic variables to realign in the direction of your investment, so that you can improve the odds in your favor.

You will probably sleep better at night in either case.