by Jeff Reeves | March 6, 2012 6:30 am
There are a host of economic troubles on the horizon, both old and new, and that has sparked debate over whether the rally to start 2012 is running out of gas. Greek debt woes, further hints that China is slowing down and lingering unemployment and foreclosures in America show that the problems are varied and widespread.
Oh yeah, and now there’s the risk of all-out war in Iran — which will not just send a shock into energy markets, but could seriously disrupt regional trade and chill investors’ appetite for risk.
Will the stock market crash in 2012 like it did last summer? Maybe. But as we saw in 2011, the sharp contraction prompted in part by the U.S. debt ceiling debacle wasn’t meant to last forever. Stocks and the broader economy bounced back nicely, and reasonably quickly. So don’t take these troubles as sign of a severe and long-lasting downturn, even if they result in some short-term losses.
However, it’s only prudent to protect yourself. After all, some sectors are going to be harder-hit than others if and when the global markets see a move lower. Here are three sectors you should tread lightly in right now — whether you are a bull or a bear — because these kind of investments will be worst-hit by any downturn in the markets:
There are a host of warning signs in China right now. The value of land sales across 130 Chinese cities fell 13% in 2011, according to the China Real Estate Index System. China’s “booming” automobile market grew a meager 2.45% in China across all of 2011. February saw the fourth consecutive month of declines in the key HSBC Purchasing Manager’s Index, a gauge of China manufacturing.
True, China still is growing. But it is growing slower. On Monday, for instance, China set its growth target for 2012 at 7.5%, down from the largely symbolic 8% rate it has used for the past eight years.
That rate still is double or triple almost every other significant economy in the world … but for investors who have set expectations so high, any slowdown could be painful.
Morgan Stanley China A Share Fund (NYSE:CAF) has rallied dramatically to start 2012, up about 16% to triple the Dow. The iShares FTSE/Xinhua China 25 Index ETF (NYSE:FXI) also is up impressively, almost 13% year-to-date. Some of the biggest individual Chinese stocks also have soared, including 8% in 2012 gains China Mobile (NYSE:CHL), 17% gains for Baidu (NASDAQ:BIDU), and a staggering 26% for oil giant CNOOC Ltd. (NYSE:CEO) since Jan. 1.
Does that sound like these increasingly negative signs are being taken into account?
This region could prove the naysayers wrong, but even if it does, you have to figure a healthy level of optimism is already baked into China stocks. In such a scenario where Chinese equities have dramatically outperformed for the last few months, the upside is limited and the downside is significantly more severe.
If you really believe in China, stick with multinationals like Yum! Brands (NYSE:YUM) or General Motors (NYSE:GM) to play the growth without sacrificing diversification. Investing in pure-play China stocks seems shaky right now.
It might be hysterics to call the current bond environment a “bubble.” But then again, it may wind up a pretty apt description.
As long as interest rates are low, it costs very little to issue even more debt — so what’s the harm in borrowing? And as long as the stock market remains choppy, the relatively lower risk of the bond market seems attractive — so what’s the harm in hiding out in bonds?
Well, you can see how this cycle will play out. More debt is offered. More people buy it. That keeps rates low. So more debt is offered. Then more people buy it …
Bubbles make people feel good at first, since they appear to be making money. The trouble is that you often don’t realize a bubble until it’s too late.
Don’t play chicken with the bond market. It’s only a matter of time before rates go up — which will cause some people to have trouble securing loans, or worse, paying the service on their existing debt. This will cause the bond market to spiral quickly in the other direction.
That might not happen this month or even this year. But it will happen eventually. Do you really need more warning signs than the fact that 10-year Treasuries are at record low yields after America nearly defaulted on its debt last year and suffered a credit downgrade?
Not all bonds will crash, of course. AAA-rated debt from more fiscally secure countries like Canada or Australia will fare better, and of course some corporate bonds will remain bulletproof — though admittedly, their poor yields leave much to be desired. However, some high-yield corporate bonds — commonly referred to as “junk” — could be highly risky. And even sovereign debt could give investors a turn for the worse.
That’s to say nothing of debt that eventually is paid back, but at rates so disappointing it serves investors no better than cash. I mean, a 2% annual return on T-notes? While the current rate of inflation is 2.9%? That’s not even treading water.
Be wary of trusting too much in the bond markets. Traders have favored bonds in the past few years, with many related investments doing quite well. But that could all change very soon.
It’s very simple logic: When conditions are favorable, the small, fast-moving companies on Wall Street post the biggest gains. They have the most to benefit as their operations grow quickly, investors jump in and push them higher and higher.
But when conditions go south? These small-cap momentum stocks are the first to sour.
That momentum already has started to wane. The Russell 2000 Index, which tracks companies with an average market value of $738 million, added 2.3% last month, compared with a 4.1% gain in February for the S&P 500, whose members average $25.9 billion in value. That’s a heck of a disparity.
There are, of course, some small-caps that will continue to swim upstream even in a tough environment. The platitude about it being a “stock-picker’s market” is always true if you happen to pick the handful of stocks that perform best. But by and large, most smaller companies are going to have a very hard time weathering a downturn that saps earnings — especially if they have been bid up to nosebleed valuations on investor optimism.
Take Tempur-Pedic (NYSE:TPX), which is up 50% in the first two months of the year. Sure, earnings and sales are going strong … but you think $1,000 mattresses are going to keep selling like hotcakes if oil hits $150 a barrel and macroeconomic fears keep creeping in?
Or the fad stock Crocs (NASDAQ:CROX), which has staged a comeback with a 33% run year-to-date in 2012? Is this the kind of diversified and innovative small-cap that you want to be holding when the music stops?
Small-caps are powerful growth investments in bull markets, but they can hurt you just as badly on the way down. If you’re uncertain about the market, be wary of high-momentum stock with a small market size right now.
Jeff Reeves is the editor of InvestorPlace.com. Write him at firstname.lastname@example.org, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. Jeff Reeves holds a position in Alcoa, but no other publicly traded stocks.
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