How to Invest Amid a Summer of All Fears

by Ivan Martchev | May 17, 2011 3:00 am

How to Invest Amid a Summer of All Fears

A former bond trader I know often used to say, “Trading bonds is the most fun you can have with your clothes on.” Nonetheless, fun is the last thing that holders of euro-denominated PIIGS debt have been having of late.

There is yet again rising stress in some of the sovereign debt markets in Europe, which needs to be taken into consideration from a short-term tactical trading perspective, as well as longer-term investment strategy.

Europe is important to investors in the United States and emerging markets, because its large size means that its problems often cause repercussions all over the globe.

As I expected, the U.S. bond market has firmed up[1] and the euro has finally sold off[2], while the Greek drama of postponement of the inevitable default has been intensifying. Two-year Greek government bonds now yield a massive 25%. That’s the bond market saying there are exceptionally high odds of a bond default or voluntary restructuring; the first is less orderly while the latter is slightly more so.

Take a look at the government yields of the five PIIGS countries, along with Germany and the United States. Three of the five PIIGS sovereign debt markets — Portugal, Ireland and Greece — have inverted yield curves (short-term bonds yield more than longer-term maturities). This is one way for the bond market to say that the state of economic affairs is notably weaker in those countries so the risk for bondholders is much greater.

country Two-Year
Government Yield
10-Year
Government Yield
Portugal 11.01% 9.06%
Ireland 12.52% 10.5%
Italy 2.91% 4.59%
Greece 25% 15.58%
Spain 3.37% 5.25%
Germany 1.78% 3.08%
United States 0.52% 3.15%
Source: Bloomberg

However, the real Greek drama will start if the bond market in Spain goes into inverted yield curve territory, as intensifying problems in the little PIIGS markets are likely to cause contagion and drive away buyers of Spanish debt. This has serious implications for U.S. investors, and is likely to cause a further surge in the U.S. dollar and the U.S. Treasury market, while suppressing equity markets worldwide, beginning as early as this summer.

At present, this outcome is impossible to predict with precision as it depends on policy decisions, but it is fair to say that European policymakers do not know what to do with Greece in particular and the PIIGS in general for fear of the inevitable domino effect. Watch the Spanish yield curve for inversion — two-year notes there yield 3.37%, while 10-year bonds yield 5.25% — as a good indicator that the domino effect has started.

Stay Away From European Financials

European banks are likely to be most affected here, as they lend into the problematic economies and have holdings of euro-denominated government bonds, whose values are declining at present, but no charges have been taken to mark down book values. The stock market has taken the charge for them as Banco Santander (NYSE: STD[3]), BBVA (NYSE: BBVA[4]) and Deutsche Bank (NYSE: DB) are all notably weak. Insurance companies like Aegon (NYSE: AEG[5]) and Prudential (NYSE: PUK[6]) may also be affected.

I recommend avoiding these companies on the long side, as they make much better short candidates right now — especially the banks.

std How to Invest Amid a Summer of All Fears

I won’t try to pinpoint an exact downside target for these stocks, as I believe that it was CLSA’s Russell Napier who said that markets are like clocks with soft hands. You can see the movement, but it is often not precise. Instead, one has to watch for clues and often reevaluate the possible scenarios. The European financials mentioned here could easily have 30% to 50% downside this summer if the more negative scenarios from PIIGS debt contagion play out.

Buy Gold on Dips, But Not Silver (Yet)

If the dollar rallies further due to weakness in Europe, gold and silver will decline more. Gold will decline less than silver, as it is a safe haven. Consider that in 2008, gold ended up on the year, while all the other precious metals were down noticeably given their more industrial nature. Gold also has central bank support as it is being used as a tool to diversify swollen forex reserves — the central banks will buy the dips.

The SPDR Gold Trust (NYSE: GLD[7]) probably has limited downside to about $130 or so, which is a great opportunity for investors that missed the latest run-up[8]. While gold bullion will remain well bid, gold miners are likely to see further correction — the smaller the company, the bigger the sell-off. This is how it has always worked out in precious metals shakeouts.

slv How to Invest Amid a Summer of All Fears

The leverage in the silver market is unwinding, and I am afraid that we will see silver in the mid-$20s this summer[9]. In my view, a $25 target for the iShares Silver Trust (NYSE: SLV[10]) is likely.

As we’ve seen since the beginning of the year, silver miners have been notably underperforming silver bullion. In fact, it got so bad that in April they were declining as silver was rallying. And we are likely to see more downside from present levels given a $25 silver scenario. You can trade this downside by going short the Market Vectors Silver Miners ETF (NYSE: SIL[11]).

However, keep in mind that this is just a correction in the precious metals bull market that has several more years to run — at least until the massive forex and trade imbalances gathered in the global economy are resolved, orderly or not. But considering that precious metals corrections can be notoriously sharp, you cannot ignore them.

Endnotes:
  1. U.S. bond market has firmed up: http://investorplace.com/37656/play-last-of-upside-in-treasurys-with-treasury-bond-funds/
  2. euro has finally sold off: http://investorplace.com/36878/spain-is-the-last-and-largest-of-the-piigs-to-fall/
  3. STD: http://studio-5.financialcontent.com/investplace/quote?Symbol=STD
  4. BBVA: http://studio-5.financialcontent.com/investplace/quote?Symbol=BBVA
  5. AEG: http://studio-5.financialcontent.com/investplace/quote?Symbol=AEG
  6. PUK: http://studio-5.financialcontent.com/investplace/quote?Symbol=PUK
  7. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  8. great opportunity for investors that missed the latest run-up: http://investorplace.com/35220/mining-stocks-and-etfs-underperforming-precious-metals/
  9. I am afraid that we will see silver in the mid-$20s this summer: http://investorplace.com/40384/do-not-get-caught-in-silver-trap/
  10. SLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLV
  11. SIL: http://studio-5.financialcontent.com/investplace/quote?Symbol=SIL

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