News Analysis date published New: 
Wednesday, August 1, 2012 - 09:30
New Date created: 
Wednesday, August 1, 2012 - 09:50
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Wednesday, August 1, 2012 - 09:30

Warning: August Could Bring More Risk than Reward for Your Investments

Wednesday, August 1, 2012 - 9:30am

Thank you Mario Draghi. The president of the European Central Bank has pledged to do whatever it takes to save the euro, and investors are already feasting on the prospects.

The mere expectation that an even deeper crisis will be averted has helped kick off a powerful rally here in the United States as well. On Friday, July 27, the S&P 500 finished at its highest levels in nearly three months.

Indeed, during the past seven weeks, the market has been repeatedly shifting course, staging sharp multi-day drops and then sharp mini-rallies. Still, the net result is a bullish one, as investors have come to embrace the likelihood that European policy makers will come up with a fix.

Trouble is, a number of other concerns have popped up, and you need to keep your enthusiasm in check.

As we head into August, here are five key headwinds that investors need to keep in mind. Chances are, the investing herd will fixate on one or several of these factors as we head into what is typically the slowest trading month of the year.

1. A lackluster earnings season portends more weakness to come.
Roughly 60% of S&P 500 companies that reported results have trailed consensus sales forecasts.

Of greater concern, the ratio of companies lowering their guidance to those raising it is -6.4%, according to Bespoke Investment Research. This means that for every 100 companies raising their guidance, 106 lowered them. That's the lowest reading since the fourth quarter of 2008. The raising/lowering trend has been negative for four straight-quarters, after nine straight-quarters of positive trends.

Unfortunately, earnings season has a few more weeks to run, and if this trend continues into mid-August, investors may have more reasons to sell than to buy.

Analysts have started to update their models to reflect the incipient weakness, but they may not have gone far enough. "Estimates have come down 3% since the start of reporting season and 5% since the start of the year. However, consensus still remains well above our estimates, especially for fourth quarter," note Merrill Lynch analysts.

2. The Bernanke option: sell on the news?
Part of the recent market strength is attributable to expectations that the Federal Reserve is poised and ready to take more stimulative action. Yet, as we saw with the first-round of Quantitative Easing (QE1) and again with QE2, much of the gains from these moves accrued to investors in advance, as many sought to sell on the news once the actual plan was released. More to the point, economists now debate whether QE1 and QE2 even helped the economy all that much, other than helping provide liquidity to speculative assets such as commodities.

3. Is the private sector growing gloomy?
In the past few years, many companies stepped up their pace of fixed investment, laying the groundwork for the capacity to handle projected growth ahead. Not anymore. These investments, which typically spread out throughout many quarters, are showing clear signs of cooling. If you assume that some of the 5.3% year-over-year expansion in business-fixed investment is the result of projects that got the green light six-12 months earlier, then the net new level of investment may not be growing much at all.

4. Short-covering may not last
The recent rally may not so much be attributable to bullish investors wading in, as much as bearish investors wading out. "We have been making the case that the recent rally was more short-covering than new demand (buyers). The technical indicators confirm this with negative divergences in price momentum and market breadth," wrote Merrill Lynch analysts in a July 30 note to clients.

As I noted in mid-July, short sales figures had dropped precipitously at the end of June. And some heavily-shorted stocks such as Sprint (NYSE: S) have since posted powerful gains.

Yet, short-covering only lasts so long. If short sellers think they have proper positioning for this market, then they are unlikely to provide further ammo by covering positions. Indeed, these short sellers may have taken a cautious stance until the ECB's Draghi and the Fed's Bernanke have made their next moves. Once those potential positive catalysts have been unveiled, the risk for short sellers fades and they may again add negative pressure (in the form of short-selling to the market).

5. Are bonds signaling recession?
The bond market is the virtual "canary in the coalmine" when it comes to expected economic activity in the periods ahead. And it's hard to avoid drawing a bearish conclusion after looking at the yields on 10-year and 30-year government bonds.

The U.S. economy grew less than 2% in the second-quarter, and most economists anticipate growth domestic product growth of about 2% in the third and fourth-quarter. But with the looming fiscal cliff inching closer, a number of businesses have grown cautious about near-term spending plans. Coupled with the fact that Europe, our largest trading partner, is showing signs of weakening further, you have to wonder whether the forecasted 2% growth can even be achieved.

The word "recession" is not yet making the rounds in circles, but we are moving closer to what economists call "stall speed." Simply put, a recently resurgent S&P 500 and a slowing economy do not square with each other.

Risks to Consider: As an upside risk, consumer balance sheets are no longer as weak as they were in 2008, so a similar retrenchment in consumer spending as we saw in 2008 may not come to pass. Moreover, signs are emerging that an increasing number of legislators understand the potentially dangerous ramifications of the fiscal cliff, raising the odds that we'll see some sort of bipartisan agreement to kick the ball down the road.

Action to Take --> A number of stocks remain quite inexpensive, and if you can ride out the near-term challenges, then these stocks should be considerably higher in a few years when the economy is on the mend.

Still, with the markets and the economy carrying so much risk right now, it might be wise to hedge your portfolio with bearish ETFs such as the ProShares UltraShort S&P 500 (NYSE: SDS) or the Direxion Daily Small Cap Bear 3X Shares (NYSE: TZA).

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.