Sunday, November 6, 2011

Should I invest in the Stock Market now?

"Mr. Market suffers from some rather incurable emotional problems; you see, he is very temperamental. When Mr. Market is overcome by boundless optimism or bottomless pessimism, he will quote you a price that seems to you a little short of silly. As an intelligent investor, you should not fall under Mr. Market's influence, but rather you should learn to take advantage of him." - Benjamin Graham

Stock Markets around the world kept plummeting the past few months, wiping away a large amount of investor wealth. However the month of October saw a smart recovery in the markets. During a time when an annual return of 10% is considered fantastic, the markets gained 10% just in the month of October! The rise in markets during October was largely due to perceptions that the Greek crisis would be contained, and perhaps even solved. As European politicians negotiated with one another, the stock markets continued to gain momentum.

However, there is a possibility that the deal reached the previous week will not be honored. There is also the possibility that the current government will not survive. The stock market expectation that this would be solved has clearly not materialized. So why are the markets not reflecting this? Is there something the stock markets know which others don't?

Let us look at some data. In stark contrast to the performance of the stock market in October, the bond market saw things differently. If you look at the performance of government bonds of indebted Eurozone countries over the month of October, the figures showed a worsening of conditions, rather than an improvement. The way in which you can measure the bond market performance is by looking at the yield spread between the 10-year government bonds of an indebted country over the 10-year German government bond. An increasing yield spread indicates that the perceived default probability has increased, and thus conditions have worsened, rather than improved. Here are the figures: Over the month of October, the yield spread of Italian over German bonds increased by 0.7%. Spanish bonds saw an increase of 0.3%, Portuguese bonds saw an increase of 1.3%, and Greek bonds saw an increase of 1.9%.It is not just the yield spread change that is concerning. The actual spread level is also very high for these countries. Currently, Italian bonds yield 4.3% over German bonds. For Spain, this figure is 3.5%; for Portugal, this figure is 9.8%; and for Greece, this figure is a whopping 23%. 

The reason I quoted this data (which is available in the public domain) is to highlight a point. Stock market investors tend to be a lot more diverse, and most of them have no direct stake in Eurozone debt failures. On the other hand, bond market investors stand to directly suffer in case of a Eurozone default. Thus, the bond market is more likely to accurately reflect the possibility of a Eurozone default, as compared with the stock market.

Whenever you see news about a possibility of European deal or something else that would fix the crisis, you should look to the bond markets for what the market expects to occur. While stock markets may fluctuate wildly, the bond markets are more stable and more likely to reflect true probabilities, given that the investors are more directly affected.

So here is what I conclude: The European Crisis is far from over and I take the risk of making a prediction that the Stock Markets will correct again. If you feel you missed out a 'good chance' to buy stocks, I believe that the opportunity to buy will come again. I do not know how soon but the markets should correct the moment the realization that the crisis is far from over, dawns upon it.

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