Think Stocks Correction Is Over? Roubini Sees 20% More Downside

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By Dian L. Chu, Economic Forecasts & Opinions

Investors are tempted back into the market after a nearly 4% sell-off on Thursday, the biggest one-day drop since April 2009, leaving stocks at more reasonable valuations. Meanwhile, Germany's parliament approved a bailout bill for Greece and other euro zone nations burdened with high debt loads also helped ease worries about sovereign debt.

Europe’s debt crisis has pushed the S&P 500 down 12% during the past month.  So, is the correction over? Nouriel Roubini does not think so. The New York University professor and economist, is predicting markets will sell off another 20% in the next few months, that cash is the safest place for investors right now.

Cash & Futures Options

In a CNBC interview on May 20, Dr. Doom says in addition to the macro problem in the euro zone, Japan, UK and the U.S., China possibly slowing down, there is also "regulatory risk because we don't know how financial reform is going to occur."

"Apart from cash I would invest in short-term government bonds of countries that don't have a serious debt problem, countries like Germany and maybe Canada, and a few other advanced economies that from a fiscal point of view are sounder than the weaker economies."

He noted investors can use options to hedge against future market downside risk that is certain to come.

Double-Dip

"There are some parts of the global economy that are now at the risk of a double-dip recession, certainly seeing that risk in the euro zone...From here on I see things getting worse."

Roubini also named Japan with its anemic growth and the U.S. when inventory adjustment goes away and fiscal stimulus becomes a drag in the 2nd half of this year, as possible candidates for a double-dip recession.

A Mission Impossible Train Wreck

Fixing the debt problems in Greece and other troubled nations would be “mission impossible." Governments need to raise taxes and cut spending. "Otherwise we're going to get a fiscal train wreck… and it's going to take years of sacrifices."

My Thoughts

The market hates uncertainty. When investors get scared, they pile into cash equivalents. Spiking treasury demand sent yields on 30-year Treasurys briefly dipped below 4%, the first time since October, while the VIX fear index has almost doubled this month to 40.10.

The market is saying it is unwilling to buy stocks given the uncertainty mainly from the euro zone, financial reform, and signs of economic slowdown in China. Commodities ranging from gold, crude oil, metals to sugar and coffee also fell as investors fled risky assets on fears the euro zone's debt crisis will crimp global growth.

Unlike the US where the Federal Reserve can act alone on behalf of the country, the European Monetary Union is quite different. European Central Bank has limited powers, and the EU cannot act alone on behalf of the euro zone.

This structural weakness could mean

  • Greece and some or all other PIIGS countries must restructure (i.e. bond holders taking a haircut) or possibly default on its sovereign debt due to unsuccessful budget cuts amid continuing protests.

And/or

  • A breakup of the monetary union when the North Europe finally gets tired and refuses to finance the Southern Europe's lavish spending habit.

A stampede out of the euro has pushed net short positions to a record high, but the euro rose broadly on Friday partly on speculation of a coordinated central banks currency intervention. This is causing a short squeeze and the unwinding of other assets.

New loans and euro currency interventions, even if confirmed, do not change the debt dynamics and the threat of a global debt contagion (see the scary chart from NYT).  International Monetary Fund's recent forecast that Ireland, the U.K. and U.S. will post the largest budget deficits among advanced economies this year, ranging from 11% to 12.2% of GDP, further point to higher market downside risk.

Meanwhile, the breach of the S&P 500 June futures contract below its 200-day average for the first time since July 2009 coupled with 500+ stocks at their lowest price in a year on Thursday could perpetuate a negative market sentiment and spill into the real economy.

In this environment, I’d recommend stay away from the stocks and bond for now, but instead of sitting on cash, investors should take a look at natural gas, copper and U.S. real estate related investment vehicles as they remain relatively undervalued compared with other sectors.

Economic Forecasts & Opinions