Soft and Yielding

Over the past two months, we’ve warned investors of the potential for the stock market to suffer another summer swoon. With the S&P 500 dipping to 1,291.98 on May 18 (down 9.2 percent from its April high), this market correction is under way. As in the past two summer swoons, the latest downdraft appears to be a classic risk-off correction; investors are selling most stocks and commodities en masse to book profits from the rally earlier in the year.

Subscribers have submitted a number of questions in recent weeks about some of the harder-hit names in the model Portfolios. With a few exceptions, these pullbacks stem from the broad risk-off trade, as opposed to company-specific developments. That being said, I updated my outlook for Chesapeake Granite Wash Trust (NYSE: CHKR) and several other laggards in Playing the Pullback, a Flash Alert issued on May 18, 2012.

The risk-off trade appears to have legs, and the recent recovery in the S&P 500 and oil prices has all the hallmarks of an oversold bounce. Three main factors are driving the current risk-off trade: weakening US economic data, Europe’s ongoing sovereign debt debacle and uncertainty surrounding US fiscal and tax policies.  

Europe’s Debt Crisis

The focal point of the European sovereign-debt crisis shifts from country to country, but the basic underlying problems of excess debt and weak economic growth are constant. Most recently, investors have focused on Greece and the country’s potential ejection from the EU if a new government backtracks on budgetary cuts.

Greece has several political parties, but the center-right New Democracy and center-left Pasok parties have dominated elections in recent years. The New Democracy party prevailed in the country’s May 6 election but won only 19 percent of the vote–well short of the percentage needed to form a government. Pasok came in a distant third, garnering about 13 percent of the vote. During the country’s last major election in 2009, Pasok had captured more than 36 percent of the ballot.

Although Greece’s two biggest political parties disagree on many points, both support the austerity measures needed to secure a bailout for Greece and ensure the country’s membership in the eurozone.

The Coalition of the Radical Left, led by Alexis Tsipras, was a surprise winner in the elections earlier this month, placing second to the New Democracy party and collecting more than 16 percent of the vote. In 2009 the party came in a fifth place and won 5 percent of the ballot.

Unlike Pasok and New Democracy, the Coalition of the Radical Left has called for rejecting the bailout terms that Greece negotiated with its EU partners. The anti-austerity party’s strong showing on May 6 suggests that Grecians are increasingly discontent with the government’s cutbacks and an economy that will likely remain mired in recession until at least 2014.

The three leading political parties failed to forge a viable coalition government after the May ballot, setting the stage for a second set of elections on June 16. Results of the mid-June ballot could be pivotal for Greece and the EU.

If the Coalition of the Radical Left and other parties that oppose the mandated austerity measures garner additional support and are able to form a government, they’ve pledged to reject the terms of the bailout agreement with the International Monetary Fund and other European governments. Since Greece can’t borrow money in private markets, the loss of foreign aid would quickly result in a cash shortage, default and the nation’s exit from the eurozone.

Intrade a website where investors can speculate on political and economic events, currently rates the probability of one country leaving the eurozone before the end of 2012 at more than 40 percent. The probability of a member state exiting the EU by the end of 2013 stands at 60 percent.

Markets appears to have priced in the potential that Greece could be forced out of the EU, though a chaotic exit from the union would likely send global equities lower.

Investors should also keep a close eye on economic and political developments in Italy and Spain, the largest of the fiscally troubled EU nations.

Yields on Italian government bonds that mature in 10 years currently stand at 6.15 percent, while Spain’s sovereign bonds of the same duration yield 5.55 percent. Yields above 6 percent are considered unsustainable.

At some point in 2012, the EU will likely have to deploy some of the bailout fund to recapitalize troubled Spain’s financial institutions.

In short, expect Europe to produce its fair share of fear-inducing headlines this summer, especially in the weeks leading up to Greece’s June 17 election.

Weakening US Economic Data

Over the past several months, we’ve also highlighted how seasonal distortions–primarily related to the unseasonably warm 2011-12 winter–have made the US economy appear deceptively strong by boosting construction activity, home sales and employment data between November 2011 and February 2012. As these seasonal tailwinds have faded, the US economy has softened.

Recent data points paint a mixed picture. For example, the number of people filing for first-time unemployment benefits spiked in April but has since declined to a four-week average of 370,000 that’s close to the March low.

Meanwhile, the Institute for Supply Management’s purchasing managers index (PMI) for the manufacturing sector stands at 54.8, its highest level in almost a year. Readings of 54 to 55 usually coincide with economic growth of 4 percent. Although investors shouldn’t expect US gross domestic product (GDP) to match this historical precedent in 2012, a PMI of 54.8 suggests there’s little risk of the economy lapsing into recession over the next six to nine months.

At the same time, the Citigroup US Economic Surprise index–a measure of how the past three months of economic data compares to expectations–has traded sideways for the past few weeks. The US economy hasn’t deteriorated to the extent that it did last summer, but growth has softened.

Despite these developments, our outlook for the US economy hasn’t changed since 2009. The economy continues its lackluster recovery from the 2007-09 financial crisis and recession; we expect GDP growth to average 2 percent to 3 percent over the next few quarters, with periods of accelerating expansion and periods where the economy struggles.

Right now, the US economy is holding up better than last summer, a development that should support domestic equities relative to what transpires in European stock markets.

The Fiscal Cliff

The US faces a litany of tax increases and spending cuts due to go into effect in 2013 if Congress fails to repeal them. If all the scheduled tax increases and spending cuts go into effect, the US would face its largest fiscal contraction since World War II and the economy would almost certainly slip into recession in 2013. 

With a presidential election looming in November, neither party has any incentive to work out a compromise. Both parties want to push their agenda and appeal to their base for support; this issue will remain in play until after the November election.

Data from Intrade currently estimates President Barack Obama’s reelection chances at 55 percent, down slightly from more than 60 percent a few weeks before the stock market began to tumble. The website puts the probability of the Republicans controlling the Senate after the 2012 elections at 57 percent and the likelihood of a GOP majority in the House of Representatives at the 75 percent.

At present, a split government appears the most likely outcome. Although the shape of any compromise on fiscal policies is difficult to project, investors should rest assured that politicians are unlikely to allow all the tax hikes and spending cuts on the docket to go into effect. The likelihood of a compromise increases if the US economy appears weak after the election.

The problem is timing. A lame-duck Congress will have less than two months to pass a deal. If they can’t agree on a deal, Congress could make the changes retroactively in early 2013–a move would generate even more uncertainty.  Several companies commented on this looming fiscal cliff in their first-quarter conference calls, a sure sign that this potentiality is already impacting their decisions.

The Verdict

We expect the headwinds buffeting the market to ensure that the risk-off trade continues. Investors should regard any near-term rally as a temporary phenomenon; the S&P 500 will likely tumble to 1,200 or 1,250 before the correction ends. We expect the selloff to drag one for at another month or two. Consider taking on the two hedge positions in my Best Buys List to blunt the effects of the ongoing pullback. ProShares Short S&P 500 (NYSE: SH) is a buy under 39, while First Trust ISE-Revere Natural Gas (NYSE: FCG) should be shorted above 15.

Income-oriented groups such as master limited partnerships (MLP) and US royalty trusts often suffer inordinately in the early stages of a market pullback. In a risk-off world, investors sell all stocks regardless of fundamentals. Less-liquid issues such as MLPs and royalty trusts tend to suffer more than the S&P 500 as a whole.

Historically, these pullbacks have proved to be excellent buying opportunities, as income-oriented names also tend to bottom out and recover long before the broader market. Investors should consider gradually building a position in these yield-oriented names. Consider putting one-third of your intended investment to work now, deploying another one-third after the Greek elections next month and investing the final tranche in late summer or early autumn.

High-yield buy candidates on my Best Buys list include Linn Energy LLC (NSDQ: LINE), which rates a buy under 40; Total (NYSE: TOT), which rates a buy under 57, Penn Virginia Resource Partners LP (NYSE: PVR), which rates a buy under 29; Teekay LNG Partners LP (NYSE: TGP), which rates a buy under 41; Mid-Con Energy Partners LP (NSDQ: MCEP), which is a buy under $26.50; and SandRidge Mississippian II (NYSE: SDR), which is a buy under 23.

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