Phew. That was close.
After a tough week, the Dow Jones index closed higher yesterday, which meant it narrowly avoided clocking up its longest losing streak since the 1970s.
But we’re not out of the woods yet. The S&P 500 has breached its 200-day moving average. You’ll hear a lot of chatter about this among the traders and those more inclined to using technical analysis. Suffice to say, it’s a bad sign.
It’s also dangerously close to 1,250, another key level on the index (it’s at 1,260 now). If it falls decisively through that, a lot of people will turn gloomy, as that would mean the index had broken an uptrend in place since the rally from March 2009 began.
But why is this happening now? What’s spooked the markets?
It’s all about growth…
Economic growth is slowing around the world
As most people realised at the time, the US debt ceiling debate was irrelevant. On the one hand, the US was never going to default over it. And on the other, the scale of the debt is so great, that politicians were never going to come to any deal that marked a decisive shift to a more sustainable future.
So why have the markets had such a rough week or so? It all boils down to growth – or the apparent lack of it. Manufacturing surveys around the world are indicating a slowdown, with activity in the UK, the US and China stalling or shrinking. Consumer spending in the US fell in June. US GDP figures were awful.
It’s not just the broad economic data that looks gloomy. Individual companies – although still reporting solid earnings – are getting jittery too. US industrial giant Emerson Electric warned last week that the “US and European economies have clearly slowed and entered a soft patch and it remains unclear if they will improve much in the second half of the calendar year.” Other groups, such as Siemens and BASF, have been similarly cautious, notes the FT.
Something that also caught my eye was Mastercard’s results. The payment processor beat earnings estimates because of a surge in usage of its debit card network: consumers are using cash more than credit when they buy.
That just sums it all up. When consumers are using cash rather than credit, that shows they are watching the pennies. That’s not good news if your economy is largely dependent on consumer spending.
With the threat of a slowdown – or even a fresh recession – hanging over investors, it’s little wonder they’re suddenly in the mood for profit-taking. As Brian Jacobsen of Wells Fargo tells the FT, “The problem with strong earnings coupled with a weak economy is that investors tend to be less willing to pay up for those earnings.”
There’s a good reason for that. Companies are part of the economy – they can’t decouple from it. So if the economy is weak, it suggests that strong earnings won’t be sustained.
Companies are also providing less specific guidance on the outlook – or none at all. That sort of uncertainty again makes investors less keen to pay up for future earnings that may not materialise.
So what happens next?
In the very short term, investors are just holding their breath to see what the state of the US jobs market is like. The US non-farm payrolls report comes out tomorrow. Last month it was extremely disappointing.
In truth it’s ridiculous that markets pay so much attention to this figure. It is regularly revised, and basing your investment decisions on it makes as much sense as tossing a coin: if it beats expectations, the market goes up. If it falls below expectations, the market goes down.
We prefer to look at the four-week average of jobless claimants. It smoothes out some of the bumps and gives a better overall view of what’s going on.
But beyond that, a lot depends on how hard the Fed hints at another batch of quantitative easing. The annual central banking conference at Jackson Hole in Wyoming is later this month. The market is expecting Ben Bernanke to discuss QE3, just as he launched QE2 there last year.
I don’t see the rationale for Bernanke to announce QE3. We know what the broad impact of QE is, even if no one can quite agree on how it works. It sends stock prices and commodity prices higher. So it makes the cost-of-living more expensive, while only benefiting people who own stocks, which are the wealthiest chunk of the country.
The Fed might worry about the impact of a stronger dollar on manufacturers, but that sector isn’t going to save the US. And in any case, a stronger dollar would also lower costs, by weakening commodity prices.
So I’d say that if the intention is to boost consumer confidence, ditching QE would be the best bet. But it doesn’t matter what I think. It’s Bernanke’s call. And he seems to regard a surge in stock prices as a form of standing ovation.
In short, if QE doesn’t happen, I can see stocks tanking. If it does, they’ll probably rally. I realise that’s not very helpful if you’re trying to take advantage of it. So what can you do in practical terms?
How to hedge against QE3
Well, if you are a regular reader, you already hold gold. Gold will rise along with stocks if QE3 is announced, so you’re already covered for that eventuality. Now if there’s no hint at QE3, both stocks and gold will fall. And any move towards genuinely tighter monetary policy would be a real warning signal for gold investors.
But I can’t see that happening. At worst, Bernanke might hold the door open to QE without actively committing to it. That would be enough to disappoint the stock market, without removing the underlying rationale for hanging on to precious metals.
So gold is your insurance. As for markets, I’d still be happy to stick with blue-chip defensive stocks. They won’t go bust in a recession, and in the meantime, they’ll pay you a decent income to tide you over. My colleague David Stevenson wrote about one such stock earlier this week – you can read the piece here: Should you buy shares in Vodafone?
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