ICangles Investment Post…

Concerns over the debt situation in Greece spiraling out of control and roiling financial markets around the world, including banks and investment companies with exposure to Greek debt, has been in the headlines lately. Some even worry the current situation could spark another global downturn. Among their number is Alan Greenspan who stated a default by Greece is a near certainty and could drive the U.S. economy into a recession. Counter-intuitively all of this concern, especially worries emanating from the fraternity of central bankers, is reason to not worry at present over the situation.

Despite writing about the dangers around debt in general and specifically mentioning the debt situation with Portugal, Ireland, Italy, Greece and Spain or the PIIGS, (see Things Fall Apart) I am not overly concerned at the moment. From a contrarian perspective there is simply too much concern at present over the situation. Bankers, investors and politicians all understand the nature of the problem and the risks involved. This is in stark contrast to previous downturns when those in power under-estimated the scope of the problem until it was too late. In fact I have been and remain bullish on the current year (see Don’t Fight the Fed).

Boxers have a saying that it’s always the punch you don’t see that knocks you out. The reason for this is pretty simple. When a fighter sees a punch coming the natural reaction is to either block it or move out of the way. Fighters don’t just stand there and get knocked out. In financial markets, as well as boxing rings, it is the unseen that accounts for most knockouts. And the problems around Greece, as indicated by the comment from Alan Greenspan, are fully appreciated. As a result, actions are being taken by those in power to if not solve the problem then at least put off the day of reckoning until later.

Examining the art of the knockout provides some further useful investing insights. Some contrarians argue if market worries are widely publicized it means investor concerns are unwarranted. But this isn’t always true. If some in the crowd see a punch coming, but the boxer doesn’t a knockout still results. What is important is whether those with the power to affect the outcome appreciate the nature of the problem. In the last downturn for instance a few pundits did loudly proclaim prescient worries, particularly about problems in the real estate market, but those able to alleviate the crisis (central bankers, government regulators, politicians, bankers) did not appreciate the severity of the threat to the credit markets. They didn’t take the actions need to avoid the resulting blow, and an economic knockout resulted. One the economy is still woozy from.

Then again there is a situation where a boxer does get knocked out by a blow he sees coming. This exception to the rule can happen when some strikes not seen and fully countered have already dazed or damaged the fighter. Off balance he is no condition to stop the final strike of the combination when it comes even if he sees it. An economic version of this might already be developing (see Painted in a Corner). The Federal Reserve of the United States reacting to the repeated economic blows it did not anticipate emanating from the recession and anemic recovery has significantly expanded the monetary base and dangerously leveraged its own balance sheet. Even if it sees a growing danger of inflation there may not be much it can do other than try to convince the market crowd that it is still in the fight. The resulting stock market decline will only really get going when investors realize how powerless the government is to address the situation.

Although I have significant concerns that we could get into such a situation where debt issues push us into another economic downturn (see More Money Problems), I believe at present market actors are both conscious enough of the risks in Greece and still have enough freedom of action left to be able to postpone the coming global knockdown to a later date. The PIIGs debt problem or issues around the debt-predicated monetary system around the U.S. dollar are still present. But it appears that aware of the risks politicians are doing the bare minimum to avoid a crisis today. The need for truly significant global reforms isn’t being addressed and probably won’t be until a crisis most don’t anticipate is upon us in a manner similar to the credit market crisis that began in 2007. Only this time with the freedom of central bankers severely limited there will likely be no choice other than for the world to follow the path the Greeks have been forced on of meaningful structural reforms.

With all that said what if I am wrong and those in power don’t fully appreciate the immediate danger from Greece or other economic hot spots? What if they don’t take the actions needed to at least forestall a downturn? Well for starters a diversified stock portfolio puts the odds in your favor as long as you stay invested over time. Someone investing in the Standard & Poor’s 500 diversified stock index in 1995 and holding onto their investments throughout both of the major bear markets remained in positive territory even at the respective bottoms. Today, they are seeing healthy gains provided they didn’t sell when things looked at their worst. A long time horizon, diversification and the discipline to not sell in panic are keys to doing well.

But if you look at the embedded chart of the S&P 500 from 1995 until today there is an included line that I pay attention to as an indicator of the market’s health—the 500-day Exponential Moving Average (EMA). Notice that from 1995 with only a single exception the stock market stayed above this line until 2000 when it entered a major bear market. In 2003 it broke back above the 500-day EMA and stayed above it until 2008 and the next major downturn. Recently the market seesawed around this line before breaking definitively above it in 2010. Given my concerns about the underlying economy if the S&P 500 again undercuts this line in a definitive manner I believe a more defensive market posture will be in order.

Of course no indicator is perfect, and while the 500-day EMA has performed well for the last 15 years and the current secular bear market it’s record in the previous secular bull market is not as strong. From 1995 until 2000 it did well, but before that in 1990 most of the damage was already done by the time the market dropped below this indicator, as demonstrated in the below chart. Then as shown in the accompanying chart in 1987 the stock market simply collapsed below this level. But the 1990 bear market was relatively benign, while a strong case can be made that the next downturn will be severe. In the case of 1987 the market crash was a unique event and one where I do not believe the drivers for such a sudden collapse currently exist (see Risky Lessons from ’87 and ’07). Given all this I believe the 500-day EMA, provided we do not get too far above it, should remain a useful indicator for adopting a more conservative investment posture in this current market cycle.