A Thinly Veiled Disaster Looms

 | Jan 18, 2012 | 4:00 PM EST
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Three months ago I wrote a column titled "Invest in the Basics," and the gist of it was simple. The strategy was to take a defensive position in equities, thus preparing for a 2012 downturn in economic activity that would likely cause a downside correction in the major indices, and particularly in growth stocks. Although the U.S. stock market has performed well since that point, I am even more concerned about 2012 now than I was then.

A week ago I wrote the column "Eerie Echoes of 2008," and since then the International Energy Agency has warned that global oil demand is now falling. This is not a decrease in the rate of growth -- it is an actual reduction in consumption of oil for the first time since the 2008-to-2009 economic crisis.

This morning the World Bank warned about the rising potential for a replay of that crisis, and perhaps worse, as it slashed nominal growth for developed countries to 1.4% from 2.7%. To be clear, this slice of the economy is defined as the U.S., Western Europe and Japan -- and a 1.4% nominal growth rate would mean a severe global recession.

At the same time, equity market indices in the U.S. and Germany have risen very strongly from their October lows: the Dow, for instance, has climbed about 18%, and the DAX has risen 22%. The Nikkei has traded sideways.  As a result, I have been inundated with calls from many asking about my outlook for 2012. There's a sense of urgency that perhaps I had gotten my call wrong, and that playing defense is not the right strategy at the moment.

It reminds me of 2005 to 2006, when I was spending most of my time counseling first-time home buyers -- usually the children of existing clients -- not to buy a home. In many cases the parents and children were almost hysterical with concern, believing if the kids didn't buy a home then, they would never be able to afford one. It was a mania, and people just stopped thinking. They were only reacting.

Before going further, though, let's take a look at the performance of the defensive and dividend positions we discussed three months ago. In that above-mentioned column, we looked at three grocery stores and two motel chains. Of that first group, Wal-Mart (WMT) is up 15%, Kroger (KR) has risen 11% and Safeway (SWY) is 30% higher. As for the motels, Choice (CHH) and Intercontinental (IHG) are better by 26% and 32%, respectively. These results don't include dividend income, either -- one of the primary drivers of this strategy.

So, that's a pretty good return. But what happens from here? Unlike the homebuilders, which I advised to liquidate last week, these are solid positions to have as we head into what's shaping up to be a severe global recession. If the global stock markets take the dramatic turn for the negative, as I expect they will, these issues will get adversely impacted, as well. However, their dividends should be strong, as they are in the staples area, and they should rebound more quickly than the overall stock market.

Away from this, I'll now briefly address the growing divergence between economic indicators and sovereign bond markets on the one side, and global equities on the other. Economic indicators are becoming increasingly negative, which has heightened concern among bond investors about the safety of their principal, and about the near-future potential for reduction in interest income. Those worries are indicated by a flight into the sovereign bonds of what are perceived to be the strongest countries. 

On the other hand, we're seeing Western equity markets "climbing the wall of worry." This has essentially nothing to do with the expectations for growth, and everything to do with that well worn idea: "Don't fight the Fed." In this case, it's don't fight the Fed, the European Central Bank, the International Monetary Fund, Bundesbank and the sovereign fiscal authorities with whom they are working ever more closely. In the normal give-and-take of monetary policy, that's usually the right attitude to take. But there's nothing normal about the current environment.

Equity investors are expressing supreme confidence in the Federal Reserve, and in other central banks, to conquer the deflationary-recessionary track of the global economy. However, those investors are not taking into account the very obvious fact that the central banks are losing in that fight. Equity investors aren't seeing what the bond investors are, because they are not looking for it. "Don't fight the Fed" has become a religious mantra.   

With that, I'll offer one last word of advice on what to do when faced with a divergence between bond and equity signals. Always follow the bonds -- always.  

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