The US equity markets are quickly moving into a very fragile condition—the slightest “disturbance” could set off a huge wave of selling, selling with little near-term bullish support that would break the fall.

On the macro front, the news flow was light due to the holiday shortened week.  Empire State manufacturing, although still very weak by historical standards, did beat estimates. But industrial production missed. Both headline producer prices and core figures were lower than expected. Consumer prices were slightly lower than expected. So on the inflation front, there seems to be very little to be worried about—in the most recent month to month comparisons. In housing news, the results continue to disappoint: both existing and new home sales were lower than predicted. And more importantly, median prices continue to grind lower. While initial jobless claims were better than expected, the Philly Fed survey missed.

Last week, we took the temperature of today’s markets and investor psychology. The verdict was that prices and spirits are on the high side.

The problem is that most investors would simply shrug their shoulders, declare there’s nothing they can do about high prices, and simply go with the flow by staying broadly invested in stock markets.

And that’s exactly how these investors—most individual and even institutional investors—unknowingly assume huge risks of big losses in the near future. Instead of employing tactics to guard against price drops, they compound risk by continuing to buy more stocks at inflated prices, specifically at prices that are above intrinsic values.

So what should an intelligent value investor do?

First, after recognizing the frothy price environment, one could sell down a 100% invested portfolio to increase the cash percentage. Another, tactic for the smaller investor would be to make sure that carefully considered stop orders are put in place to protect unrealized gains from the last two years.

Third, the intelligent investor must be prepared to look for bargains outside of the mainstream large cap pools like the S&P500.  This way, the investor will never be temped to break the cardinal rule of value investing—buying a stock at prices below its true value.

Where can you find such bargains today, at a time when the S&P500 is more than fully priced?

In the US, you’ve got to dig through the small to mid cap firms in the Russell 2000. For example, you could consider a stable, unglamorous medical products maker called Invacare.  Down from $34 just six months ago, you can today buy shares at about $16, which represents an astoundingly cheap 4 times free-cash-flow valuation.  This is about 7 times projected earnings, and only 8 times EBIT for the entire enterprise value. Why did prices fall so much? The firm suffered a technical problem at one of its wheelchair manufacturing plants. Most likely, this is a temporary setback, creating a temporary hit to price (not a permanent hit to value) resulting in a short-term opportunity to buy shares at prices about 50% below true value. Even if share prices were to double, this would bring price-to-free-cash-flow up to only 8……still not over-priced by most standards today.

Other similar bargains abound…..but in Europe, for example, which has taken a beating in market prices over the last six months. Today, large cap, stable drug and telephone companies can be purchased at price-to-free-cash-flow multiples that are near 5. That’s cheap. In many cases, only months earlier, prices were 100% higher.

The bottom line is that there’s NO reason to break the value discipline. In today’s frothy US stock markets, it’s much harder to find screaming bargains. But they do exist. It simply means that an investor must look harder and more widely to find them.

US economic news took a turn for the worse, disappointing on multiple fronts, starting with wholesale trade, which barely grew, instead of rising at a strong 0.5% rate. Initial jobless claims roared back to the 400,000 level associated with economic recessions. Retail sales were horrible. Instead of rising 0.4% as expected, they managed to creep up only 0.1%. What’s worse, the more important retail sales ex-autos results collapsed. Instead of rising 0.4%, they fell 0.2%. Business inventories (a key driver of GDP growth) rose far less than predicted. International trade was far more negative than expected, and export prices were far weaker than consensus estimates. Both of these results suggest that the economy was growing more slowly in the fourth quarter of 2011.

Technically, the S&P is very overbought on the daily charts. And it’s showing signs of losing momentum.  It seems that it wouldn’t take much for the upside momentum to stop completely and reverse to the downside. Greek default, anyone?

Last week, we reviewed the insightful investment advice that was provided by Howard Marks in his new book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”.

The key insight noted here was the need to take the market’s temperature periodically, to assess if the markets were too optimistic, too pessimistic, or somewhere in-between (or neutral). This type of analysis is much easier to do, and it’s far more accurate, that what almost every professional investor does instead–forecast the near future, place his bets, and hope that the actual outcomes match the predicted future. Because in the predicted future comes to be, then the bets should pay off handsomely. But if the predicted future fails to arrive, then the bets will not pay off.

Marks noted that most professional investors and even most professional economic forecasters have a horrible track record with their forecasts.

So instead of betting on consistently inaccurate forecasts, investors would be better off if instead they focused on reading the present, on taking the temperature of today’s markets.

And today, we can easily rule out that idea that markets are pessimistic. After rebounding smartly off their 2009 lows, equity and credit markets are certainly not running scared today as they were back then.

In fact, by several measures that Marks uses, markets are more optimistic than they are neutral. Equity investor surveys are decidedly more bullish than they are bearish. In the credit markets, interest rates are very low; money is eager to lend at tight spreads, especially for investment grade bonds. Corporate profits aren’t just high, they are near record high levels (as a percent of sales). Asset owners are happy to hold; certainly they’re not rushing to sell. Asset prices are on the high end of multi-year ranges.

As a result, Marks would conclude that since, today, prices are on the high side, that risk is also on the high side. Therefore prospective returns are on the low side.

It bears repeating that “taking the temperature” today is not a forecast for tomorrow.  Instead, it is a determination that being fully invested today raised the odds of lower future returns.

So what’s a professional investor to do….with this type of temperature reading?

Marks would offer several pieces of actionable advice. First, don’t take on much more risk when it’s so high today. In fact, consider reducing risk, by selling it down. And certainly don’t break the golden rule of value investing (of buying assets below their intrinsic values) by overpaying for assets. Another related part of this advice would be to increase the percentage of your portfolio that’s held in cash, to be ready for times when prices (and risks) are lower, and to lessen the damage that could result from market corrections, corrections that are more likely to occur in overly optimistic markets (than in overly pessimistic markets).

Again, without knowing anything about the near future—and without making any attempts to forecast it—our temperature reading of TODAY’S markets is flashing a caution sign. It’s telling us to be careful about higher risks today, but also to be prepared to accumulate assets, at lower prices and lower risk levels in the future, should they become available.

Words of wisdom indeed.

Economic news in the US was mixed. In Europe, on the other hand, a serious recession has started to bite.  From Italy, to Spain, to France and even to Germany, most leading and coincident indicators are pointing down. In the US, ISM manufacturing, while weak, was slightly better than expected. ISM services, on the other hand, disappointed. Factory orders also disappointed. Initial jobless claims matched expectations. The big number of the week, the jobs report, beat expectations, at least on the surface. Headline unemployment dipped to 8.5%, while the broadest measure (U-6) was still at a horrific 15.2%. The broader–and thus harder to manipulate–measures were grim. The labor force participation rate and the employment to population ratio both came in at or near multi-decade lows. Also, the workforce dropped by about 50,000 people—not a sign of an improving job market (which would show a growing workforce). Finally, as economist Dean Baker pointed out, the positive surprise on jobs was misleading and all of it had to do with season hiring that will promptly be reversed in the next two jobs reports.

Technically, the S&P is at the upper end of the declining trend first established in May and June of last year. Seemingly, while the rest of the world’s equity markets have deteriorated between 10% and 25% from their 2011 highs, the S&P has massively outperformed the rest of the world. In the upcoming weeks, we’ll see if the US markets (about 25% of global market capitalization) or the rest of the developed and developing markets (about 75% of global market cap) are correct. One of these two groups is “wrong” and will very likely converge with the other.

Last year, Howard Marks (the founder and chairman of an investment fund with $80 billion under management) released a book titled “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”.

As a value investor, with over 40 years of investment management experience, Marks assembled a series of tips for investors who wish to succeed over the long-term, as he has.

And coming from the Graham & Dodd (Warren Buffett) school, Marks builds on the hugely successful (yet so difficult to replicate) foundation established by them almost 100 years ago.

Marks goes on to add several critically important pieces of advice, advice that he’s used to build his 40 years of success.

One that stands out is the importance of taking the temperature of the economy, the markets, and investor psychology. Even if only once or twice a year, it’s imperative that investors determine if these three areas are too hot, too cold, or just right. Notice that Marks is NOT suggesting that it’s important to determine where the markets are going in the FUTURE. Most of such forecast research is not consistently accurate; in short, it’s not possible to do this consistently. Instead, Mars is suggesting that it’s important to determine where things stand RIGHT NOW; in short, this is very doable–consistently and accurately.

If they’re too hot, investors must reduce risk, by selling risky assets such as stocks. If they’re just right (which is much of the time), then investors can stay invested. If, finally, they’re too cold, then investors must, add risk, by purchasing assets such as stocks.

Marks observes that almost all market participants will do the exact opposite—they’ll buy when things are booming (hot), and they’ll sell when things are gloomy (cold).

This presents the astute investor a huge opportunity:  to buy low and to sell high……as most participants claim they actually want to do.

But Marks also adds some words of caution. He points out that by following such a “contrarian” investment strategy, an investor must be prepared to spend long stretches of time looking like he was wrong, before the markets (and the economy and psychology) revert back to more normal levels…..proving that the astute investor was ultimately doing the right thing.

These can be lonely times for such investors. But history suggests—very clearly—that although they don’t capture most of the gains in up markets, they do avoid most of the losses in down markets. And by doing so, they manage to stay in the game, and ultimately….over the long-term….have superior track records.

Macro news was mixed.  The Case-Shiller home price index disappointed. Home prices fell more than expected, to all time post-bubble lows. Consumer confidence surprised to the upside, although it’s still near depressed levels. Initial jobless claims came in worse than expectations. And Chicago PMI was better than predicted. Internationally, especially in Europe, macro data was broadly disappointing. Europe is almost certainly entering a recession.

The year-end results for stocks are notable. The S&P500 lost a fraction of a percent to close at 1,257. The Nasdaq finished the year down 1.8%, and the Russell 2000 fell 5.5%.

What makes the losses notable are the year the predictions—from the Wall Street experts—made a year earlier.  Goldman Sachs predicted that the S&P would close between 1,450 and 1,500. Barclays, at 1,420.  Merrill Lynch at 1,400.  And Blackrock at 1,350.

The point is that not only did the “pros” get it wrong, but that they all missed by a wide margin and in one direction—they were all too optimistic, as is typical for Wall Street experts.

Why?

Because their job is not to be right.  Their job is to sell.  And it’s almost impossible to “sell” customers, or potential customers, on buying stocks when you issue bearish forecasts, even when you have reasons to be concerned about the chances of a stock market advance.

In short, Wall Street “pros” are paid to lie, to con investors into buying products that may or may not be in their best interest to do so.

And what’s just as odious is the way Wall Street “pros” disparage anyone who promotes investments that they do not sell, even if the investments are blowing away the performance of equities.

Witness gold.

Not only did gold finish the year UP about 10% (vs. a small loss for the S&P), but gold has RISEN for 10 consecutive years, while the S&P has barely gained any ground over the same period AND has gone on massive “roller coaster” rides, up and down, in the interim.

Yet ask any Wall Street “pro” to describe a gold investor, and you’ll hear the term “gold bug”.

The implication is clear—if you decide to buy (and dare to actually hold for an extensive period of time, as opposed to trade) gold, then you must be some sort of nut job, or a bug, who must be psychologically disturbed to want to own such a “barbaric relic”.

But once again, gold has been UP 10 years in a row.

It’s ironic then, that Wall Street “experts” are still pushing a product class—stocks—that have so massively UNDER-performed gold, and at the same time, are mocking gold investors.

If this keeps up, shouldn’t stock investors be the ones who are mocked? Shouldn’t stock investors be called “bugs”, or better yet, stock bugs?

In economic news, the data were again mixed for the US and negative for much of the rest of the world.  At home, housing starts beat expectations, but virtually all of the beat came from apartment starts, not single family homes, which are still stuck at multi-decade lows. Meanwhile, existing home sales missed badly.  Median home prices—down 3.5% yoy—continue to grind lower for the fourth consecutive year.  The US housing market is still falling. It’s showing no signs of turning around. And just last week, the NAR admitted that it had overstated existing home sales every year since 2007 by over 14%, on average. So the housing crash, as bad as it was first looked, was actually even worse. The final revision to 3rd quarter GDP missed, coming in at 1.8%, worse than the 2.0% consensus estimate. Initial claims beat expectations, as did consumer sentiment. Durable goods orders, when stripped of airplanes and defense, were far worse than predicted; they fell 1.2% instead of rising 1.0%. Perhaps the worst numbers of the week were personal income and spending. Both missed badly, suggesting that consumers are fast running out of fuel (incomes) needed to boost the largest component of future economic growth (consumer spending).

Technically, the S&P is still in a multi-month downtrend.  The peak for the year was reached at the end of April, and the S&P has been trending lower ever since. In fact, the S&P is now up for the year by LESS than 1%.  The path taken to this almost UNCHANGED level has looked like a roller coaster ride, but at the end of the year, the stock market looks like it may end up very close to where it started.

On of the ways to judge whether the US stock markets are fairly valued is to compare them to where other major asset classes are trading, specifically asset classes that have a high positive correlation with stocks.

For example, of another correlated asset class has surged far ahead of the S&P, then traders could argue that stocks have more room to “catch up” with that asset class by rising further. In other words, the S&P could be argued to be undervalued.

So how does the S&P stack up against other major asset classes near the end of 2011?

Let’s start with Treasury yields, specifically the US 10-year.  First, let’s point out that the S&P500 has been—especially over the last three years—positively correlated with 10 year Treasury yield.  Also, it’s important to note that the Treasury market is a major (by size) asset class that competes with equities for capital.

The 10 year yield, as it turns out, is near historical lows.  At the current 2.0% yield, the 10 year is implying that the S&P should be well under 1,000 and closer to 800.  In other words, the 10 year Treasury is implying that the stock market is highly over valued.

Next, let’s look at the euro. The euro has also has a consistently positive correlation with the S&P.  And over the last six months, the euro has been in a clear downtrend. At its current level, the euro is implying that the S&P should be well under 1,000 and closer to 900. The euro also says the S&P is overvalued.

International equity markets are also critical to compare to US stocks. The MSCI EAFE index is the benchmark for developed market stocks and is a great way to compare relative value with the S&P500.  And the correlations are very high.  Unfortunately, the EAFE index is down substantially for the year, wiping out, in fact, all of the gains from 2010, and then some. The EAFE index is implying that the S&P500 should be closer to 1,050.  By this measure, the S&P is overvalued.

Now let’s look at industrial commodities—oil and copper. Both do have a strong positive correlation with the S&P. Yet in this case, both are roughly in sync with the S&P.  Oil is implying the S&P is fairly valued; copper is implying the S&P is only slightly overvalued.

Finally, let’s look at high yield corporate bonds, which trade very much like equities due to their greater sensitivity to business cycles—like stocks, high yield prices rise a lot in good times, and fall a lot in bad times. Here, we find that high yield is actually prices above where stocks are priced. So high yield is implying that the S&P is slightly undervalued.

Putting it all together, we find that three markets, Treasuries, the euro, and EAFE, are pointing down for stocks. Commodities are saying stocks are fairly valued. And high yield corporate debt is saying stocks are slightly undervalued.

The final verdict? US stocks are slightly overvalued.  And since these correlations are fairly strong, there’s a very good chance that this overvalued condition will correct itself in the first half of 2012.

Macro results were mixed to weak.  Retail sales started out the week with a big disappointment. It seems that despite the Black Friday hype, the total sales tallies were not as strong as hoped for, both with and without auto sales.  Producer prices were basically in line with expectations, as were consumer prices.  Inflation isn’t becoming a problem, which makes sense in an economy that has never really recovered.  The Empire State manufacturing survey beat expectations, but industrial production missed badly.  And initial claims have now dropped below the recessionary 400,000 mark, more likely because the unemployed are running out of benefits, less so because they found jobs.

Technically, the short-term (daily) charts have returned to a bearish bias, after last week’s losses. On the weekly charts, the downturn that began in late April (which was officially the high point of the year) is still in full effect.  The bearish argument is that the subsequent peaks formed since late April have each been lower and lower.  The bullish argument is that the early October low has held, and that the subsequent lows have been higher. Very soon, this tug-of-war will resolve itself; technically, there’s very little room left in this multi-month triangle than should lead to s breakout, either to the upside or the downside.

Last week, as the years winds down, the blog ZeroHedge featured a post that assembled a list of “50 economic numbers about the US that are almost too crazy to believe”.

The main point, obviously, was to use some basic (hard to dispute) data to build a case that the US economy not only hasn’t really recovered from the Great Recession, but that it’s still in a recession, or more likely the Lesser Depression, as Nobel prize-winning economist Paul Krugman describes it.

Here are some highlights:

A staggering 48 percent of all Americans are either considered to be “low-income” or are living in poverty.

The average amount of time that a worker stays unemployed in the United States is now over 40 weeks.

There are fewer payroll jobs in the United States today than there were back in 2000 even though we have added 30 million extra people to the population since then.

One recent survey found that one out of every three Americans would not be able to make a mortgage or rent payment next month if they suddenly lost their current job.

19 percent of all American men between the ages of 25 and 34 are now living with their parents.

The retirement crisis in the United States just continues to get worse.  According to the Employee Benefit Research Institute, 46 percent of all American workers have less than $10,000 saved for retirement, and 29 percent of all American workers have less than $1,000 saved for retirement.

The six heirs of Wal-Mart founder Sam Walton have a net worth that is roughly equal to the bottom 30 percent of all Americans combined.

Child homelessness in the United States is now 33 percent higher than it was back in 2007.

Today, one out of every seven Americans is on food stamps and one out of every four American children is on food stamps.

A staggering 48.5% of all Americans live in a household that receives some form of government benefits.  Back in 1983, that number was below 30 percent.

During the Obama administration, the U.S. government has accumulated more debt than it did from the time that George Washington took office to the time that Bill Clinton took office.

Another point important point has nothing to do with the economy and the effects on markets, the subject matter that most often dominates blogs like this one.

Instead, the takeaway is more fundamental.  It goes to the heart of our social and political system.  While horrific economic numbers like these certainly could lead to lower stock prices, these trends could also lead to something far more dire.  More and more astute observers are pointing to the parallels between these trends—in prior eras—and complete social breakdown.  And such breakdowns rarely occur peacefully; instead, they often lead to civil war and broader interstate war.

If these economic trends continue, a collapse in the stock market could be the least of our worries.

On the economic front, the US data continues to hang in there, despite signs of rapid slowdowns in Europe, Asia (China and Japan), and Latin America.  US factory orders disappointed, by falling more than expected.  ISM Services badly missed; remember that services are the dominant segment of the US economy.  Initial jobless claims dropped back below 400,000, but as usual (with a virtual 100% track record), the prior week’s figure was revised higher (worse). International trade, while still in a massive deficit, was slightly worse than expected. Consumer confidence was slightly better than forecast, but still at abysmally low levels given that the economy is supposed to be in a “recovery”.

Technically, the S&P is still in a bounce formation, but it’s sitting at a major testing level—the 200 day moving average, which is now sloping downward (not a healthy sign).  The hope among bulls is that the almost “taken for granted” Santa Claus rally will push the S&P above the 200 day, allowing the stock market to finish strongly. Interestingly, as of Friday’s close, the S&P is still DOWN slightly for the year, despite the hugely volatile swings, both up and down, over the last four months.

Last week, stocks ended with a strong final day, spurred on by the latest—of seemingly dozens—of eurozone “fixes” that are in fact nothing but thinly disguised gimmicks design to fool the markets into believing that all is well.

Two years ago, such gimmicks lasted about six months, before markets saw through the lies and started selling—-stocks, corporate debt, and sovereign debt.  Then earlier this year, the gimmicks lasted a month or two, before the selling began. Lately, it seems as though the gimmicks “work” for a few days or at most a few weeks, before the ugly truth sinks in.

So this time, it might be useful to get a sampling of opinions from leading media outlets and their most respected journalists and thinkers.

From the Financial Times:

“Near-Term Risk to Peripheral States Remains”

“Amid all the heated speculation about the European Union summit’s impact on Europe’s economic future and Britain’s role in it, traders are asking a more mundane question: “Has it done enough to get us through to Christmas?” Their answer: probably not.”

From the New York Times:

“Europe’s Latest Try”

“We’re losing count of how many European Union summit meetings have ended with “historic” agreements to contain the euro-zone debt crisis only to see them fall apart as markets judged they were inadequate or irrelevant to the problem of making good on old debts and generating enough growth to pay off future obligations.

We are not optimistic that Friday morning’s agreement on a “new fiscal compact” for the euro-zone will now break that cycle.”

From Paul Krugman, on his NY Times blog, in describing the most recent “fiscal union”:

“The Orwellian Currency Area”

“… the relentless wrong-headedness of the Europeans, their insistence on seeing their crisis as something it isn’t, and responding with actions that deepen the real crisis, has been a wonder to behold. In the 1930s policy makers had the excuse of ignorance; there was nobody to explain what was happening. Now, their actions amount to a willful disregard of Econ 101.”

From The Telegraph:

“The Eurozone Banking System on the Edge of Collapse”

The European Central Bank admitted it had held meetings about providing emergency funding to the region’s struggling banks, however City figures said a “collateral crunch” was looming.

Why?

The markets cheered to an emergency intervention by the world’s leading central banks, which banded together to provided slightly cheaper dollar funding to the ECB so that it could then feed the dollars to the dollar-starved banks within the eurozone.

Almost universally, the world’s leading financial and economic experts expressed surprise at the equity markets’ reaction, noting that the substance of the action was almost trivial. And to support the argument that stocks over reacted, almost all other risk markets reacted far less seriously. US Treasuries for example, in a true risk-on environment, would be expected to sell off massively. Yet they barely budged, suggesting that the wise folks in credit land are far less optimistic about this central bank move.

In fact, many have argued that for the central banks to throw out another crutch to capital markets, the central banks must have been very worried about how fragile the European financial system actually is. Some funding statistics were flashing red, suggesting that conditions were returning to the near meltdown state last seen in 2008. What’s scarier is that these funding sirens were not turned off by the central bank scheme. These funding stresses are still flashing red.

Economic data were mixed in the US but decidedly bearish in the rest of the world. New home sales disappointed. The Case-Shiller home price index disappointed. Chicago PMI beat expectations. Initial jobless claims crept back up over 400,000. ISM manufacturing came in ahead of expectations. Nonfarm payrolls missed expectations slightly. The headline unemployment rate beat, but only because three hundred thousand unemployed folks abandoned the workforce. Reflecting similar trends, the labor force participation rate fell to a new secular low, the lowest rate since 1983. Average hourly earnings fell; they were supposed to rise. And the average duration of unemployment rose to 40.9 weeks, the highest level ever recorded.

In Europe, PMI readings across the major eurozone  states are all in contraction territory, almost confirming that Euroland is already in a recession.  China’s most recent PMI also plunged into the 40′s, which is a stark warning that its economy is about to hit the reefs.  And Japan’s latest export figures have been plummeting.

Technically, the S&P in merely one week has completely eliminated its oversold status, from the prior week.  As suggested here last week, a bounce was due.  We more than got one.  And given how the markets are now reacting almost perfectly in concert with government interventions, it’s  now very difficult to tell which way the next couple of weeks are headed.  If hints of further intervention keep arriving, then there can certainly be more upside movement in stock prices.

But sooner or later reality—or gravity—will kick in. It always does.

In fact, one of the world’s prominent experts on global financial and economic matters, Willem Buiter, recently published his outlook for Europe, and it was not good.

Simply put, Europe will either choke slowly for the next ten years, or it will die suddenly of a heart attack.

Assuming Europe doesn’t die of sudden cardiac arrest, Buiter condemns the continent to recession over the next two years.  And eurozone output won’t recover to its 2008 level until after 2016.

As a result, Buiter believes that Europe overall picture will be “similar to, or below” Japan’s Lost Decade.

Terrific. And keep in mind, Buiter is assuming that Euroland will not implode in the meantime.

So the stock market can merrily whistle past the graveyard, as it did last week, and several times in late 2007 and early 2008. But one of these days, weeks, or months, the policy gimmicks will no longer fool even the perma-bulls in the stock markets.  Credit markets seem to better understand the downside risks, and sooner; stock markets always seem to be the last to ones to “get it”.

But “get it” they will. They always do, in the end.

In macro news, the US data was mixed to negative.  While the number of existing home sales rose slightly more than expected, the median price fell almost 5% year-over-year.  The second revision for Q3 GDP growth came in far less than expected, at 2.0%.  Durable goods orders fell, but they fell less than predicted.  Personal spending rose less than expected; incomes rose slightly more.  Initial jobless claims were slightly worse than predicted, as was consumer sentiment.

Technically, the October bounce is officially over.  The downtrend that began on the daily charts is continuing at a dizzying pace. In fact, it’s very possible that we’ll see a bounce because stocks are oversold on a daily basis. More worrisome are the weekly charts, where the S&P500 is looking like it could head right back down to its October 4 lows and break beneath them.  The next important level of support would be around 1,010 the lows touched in the summer of 2010.  Should this level not hold, there is very little support anywhere in the entire 900-1,000 range.  The S&P would be in danger of zooming toward the levels reached in late 2008.

The reason for last week’s plunge was—as predicted—escalating the Euroland crisis.  Sovereign bond yields in Italy, Spain and Belgium exploded wider.  The yield on the Italian 10 year, for example, closed at 7.26%. It was under 5% as recently as August—just a few months ago.

In some ways, the markets are beginning to price in the sovereign and bank destruction of the rest of the PIIGS, especially Italy and Spain.  Is the demise of these two nations fully priced in? No, not at all. Especially when one considers the likely contagion effects.  It’s perfectly plausible that if Spain and Italy implode, then not only would their economies collapse into depression, but that the entire eurozone would be at risk of collapse.

And that’s precisely what the markets are just beginning to price in—the effects of a eurozone collapse on the strongest core economies: France and Germany.

How do we know this?  The same signals that raised red flags for the weakest of the PIIGS two years ago—widening sovereign spreads and CDS.

French government bonds, for example, have almost always traded very tightly with German Bunds.  Until now.  At one point last week, the French 10 year was yielding two times more than the German 10 year.  The markets are beginning to price in the effects of a collapse in Italy and Spain on France.  And if this spread to Germany keeps widening, the markets will be effectively pricing in the break-up of the entire eurozone.

The most grim indicator of the impending collapse of the eurozone began to surface last week.  German government yields began to turn up. Up until now, when PIIGS’ yields widened, money flowed into Germany, pushing down the yields on the Bunds.

For the first time, scared money is leaving the eurozone entirely.

Where is it going?  To the least ugly alternative, for now: the US. Treasury rates have continued to grind down, finally crossing under those of Germany.  And the US dollar has been grinding higher, in an almost perfectly inverse relationship with the euro which has been grinding lower.

Folks, this is getting ugly.

Is this it, the end of the eurozone, right here, right now? Probably not. It would be very surprising if the financial and political elites did not pull another rabbit out of a hat, if only to buy some more time before the eurozone ultimately implodes.

But this is only a matter of timing.  Today, it seems almost certain that, sooner or later, the eurozone will collapse, and by doing so, a tsunami of financial and economic destruction will crush the rest of the world.

While Euroland macro data was downright recessionary, the US data was mixed, for now.  Producer prices rose slightly less than expected. The same thing happened with consumer prices.  Industrial production was slightly stronger than predicted.  Initial jobless claims were just under 400,000 but as many insightful analysts point out, the drop in claims has more to do with folks losing benefits, rather than with these people getting jobs. The Philly Fed survey disappointed, and the index of leading indicators came in a bit stronger than expected.

Technically, the downtrend has returned in the S&P500, in the daily charts.  In other words, the strong bounce that dominated October looks like it’s been killed.  The key question is whether this downturn will turn into something ugly, or will it merely be a minor pullback?

And for clues to the answer, we turn to the source of last week’s selling, the eurozone.

Two weeks ago, Italy’s sovereign debt market began to implode, meaning that bond prices melted down and bond yields skyrocketed. As if this wasn’t problem enough, last week several other non-core European states joined the bond market meltdown party.  Spain, for example, saw its bond yields soar to new crisis highs.  And the big problem is that if Italy—the third or fourth largest national borrower in the world—is too big to save, then certainly the combination of Italy and Spain are also too big to save.  Together, if they melt down completely, these two bond markets will almost ensure the collapse of the eurozone.

To add insult to injury, the investors in these wobbly government bonds—mainly large banks in Europe (and around the world)—are also starting to teeter.  French banks, German banks, Italian banks, Spanish banks, British banks, and even US banks were getting slaughtered in their respective markets—both from the equity and credit side.

And there’s more.  As more of the eurozone begins to suffer from financial contagion, the two most important “core” sovereigns have begun to teeter.  France’s government bonds began to sell off, and sell off severely…..especially last week. Investors are worried, rightly so, that France is no longer a triple A credit risk, and are fleeing before a downgrade materializes and far more severe losses are imposed in the French bond market.

Finally, even Germany has begun to feel the pressure.  Investors are wisely asking—if can no longer assist Germany to prop up the rest of the PIIGS, can Germany go it alone?  Sadly, but correctly, the answer seems to be no.  And this is being expressed in Germany’s CDS spreads which have steadily been widening, especially over the last two weeks.

What’s also interesting is how the global media is finally starting to drop hints that something awful is brewing in Euroland.  Here are some very fresh comments from around the world:

“Many investors are no longer just fretting about the possibility of a default here or there. They are now starting to worry about the chances of the euro itself breaking up.” (Financial Times)

“The euro is still relatively stable but bond markets are screaming distress. “One of them is wrong. We suspect the bond markets are right” ” (Financial Times)

“The big danger for some investors and strategists is that eurozone bond markets might be broken beyond repair. Matt King, a credit strategist at Citi, thinks the point of no return was passed long ago. He compares the situation to the triple A collateralised debt obligation market in 2008 when investors rushed to sell at almost any cost. But the scale of the problem is bigger than in 2008.” (Financial Times)

“Nervous investors around the globe are accelerating their exit from the debt of European governments and banks, increasing the risk of a credit squeeze that could set off a downward spiral.” (New York Times)

“Experts say the cycle of anxiety, forced selling and surging borrowing costs is reminiscent of the months before the collapse of Lehman Brothers in 2008.” (New York Times)

Wow!

Several times over the last year, we’ve suggested that observers get some popcorn, and get ready for the financial fireworks that would soon explode around the world.

Perhaps, instead, now is a good time to put on a seat belt!