In the last two weeks, volatility has returned to the markets, even as Tuesday delivered one of the broadest rallies of the year. Despite recovering from its recent selloff, I believe the market is vulnerable here. There is a high probability that we repeat the experience of 2010 and 2011 where stocks start to pull back significantly in the second quarter as the crisis in Europe comes back on investors' radar screens. The situation is once again dire, especially in Spain, and it will cause the market to turn over in the near future. Perhaps we have hit the highs in the market already for the year, or the markets might hang on until Facebook's IPO in May, but the odds of a significant pullback have substantially increased over the past month. Investors should be prudent here and raise cash because I believe there will be lower entry prices by summer, if not sooner.
Ten Worrying Signs From Europe
- Insuring against Spanish debt default through Credit Default Swaps reached record highs last Friday. Given the country's 23% unemployment, huge budget challenges and contracting economy, it's hard to see how Spain makes it through summer without needing additional measures from the European Central Bank. If investors thought Greece affected the markets, wait until they experience Spain.
- President Nicolas Sarkozy is very unlikely to win a second term in France. The socialist Francois Hollande looks to be the likely victor. Not only will this rock this relationship with Germany, but it could open the various bailout agreements to "renegotiation," which certainly will not be good for the markets.
- Although tiny Cyprus is unknown to most investors, it has massive problems, including $200 billion its banking system has in loans (eight times its GDP), a good portion in neighboring Greek banks and in its sovereign debt. It is hard to see how Cyprus does not go the way of Iceland.
- If Spain did not have enough to worry about internally, Argentina has nationalized YPF SA (YPF), a majority of which is owned by the Spanish oil company Repsol (REP). Other Spanish companies that could be affected by Argentina's march to become the Russia of South America (Apologies to Hugo Chavez who has been wanting that crown for a decade) would include Telefonica (TEF) and Banco Santander (STD), which have assets in Argentina. This is the last thing Spain needs now.
- In desperation, Spain is trying myriad initiatives to crack down on massive tax fraud. Unfortunately, although this may raise some tax revenue, they will also suppressed economic activity significantly given the size of the underground economy in the country.
- The push for additional funds from the International Monetary Fund is hitting a snag as it tries to raise new money to backstop the crisis in Europe. Emerging-market players are holding up the process as they try to leverage this need to accumulate greater IMF voting power.
- Despite numerous ECB efforts, capital flight out of troubled European countries is accelerating.
- The effects of the ECB's Long-Term Refinancing Operation (LTRO) are already wearing off, and some are already predicting the ECB will now have to engage in massive quantitative easing actions.
- In an unintended and dangerous consequence of the LTRO, Spanish banks' average net borrowings from the ECB reached $300 billion in March, a 50% increase over February.
- Fifty-Five years after the Treaty of Rome, Europe's integration never has looked more in doubt. Unless radical measures are taken soon, Europe's disintegration is all but certain, with Greece and possibly Portugal leaving as soon as this year as their citizens grow increasingly unwilling to put up with austerity measures.
Given this outlook, I would also avoid manufacturers with more than 15% of their sales in Europe. I would hold or raise cash in preparation of a pullback, which should happen by summer at the latest. Until then, new money should be allocated to defensive sectors (healthcare, consumer staples and the like) with good dividends that get the vast majority of their sales domestically.
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