The Spark?

The S&P500 slipped 0.4% last week on slightly higher volume.  The VIX (or fear) index inched up as well.   Over the last eight weeks, the S&P has bumped around the 1,100 level which has proved to be a strong resistance level as many traders had expected. 

The economic data were mixed.  Producer prices jumped more than expected as the recent run up in commodity prices is beginning to show up in manufacturers’ costs.  Consumer prices, however, have yet to see the effects these upstream costs; the CPI came in modestly higher, as expected.  The Empire State Manufacturing Survey was much weaker than consensus, but industrial production and the Philadelphia Fed survey were both better.  Finally, the weekly jobless claims were weaker than projected, and the total of all continuing claims (at almost 10 million) continues to hit all-time records.

Technically, the daily charts point to a consolidating S&P at toppy levels.  Although prices are near cycle highs, a multitude of other indicators are still flashing negative divergence signals.  The weekly charts are also toppy with several indicators pointing to a looming price correction.  The monthly, two-year old, bear market downtrend line is still in effect. 

So what will it take for investors and traders to sell?  What are the possible early warning signals that could push prices down and finally bring about the much delayed correction?

Well, the groundwork has been laid.  Since the Fed’s liquidity pump has almost perfectly coincided with the runup beginning in March, the shut down of this pump would take a lot of tailwind away from the upswing.  Last week, the Fed did exactly that.  While the pump has not yet been fully shut down, the Fed announced that it will proceed with its scheduled wind down of various liquidity programs between February and March 2010. 

One media reporter likened this to the loudspeaker announcement one hears in a store that’s about to close: “attention shoppers, the store will be closing in 15 minutes”.  The Fed will be shutting the liquidity party down over the next 90 days.

How about the actual spark, the trigger to instill a sense of fear in the capital markets, the fear that would cause investors to sell riskier assets such as stocks?

One of the most likely sources will be a sovereign default.  Several weeks ago, Dubai (a tiny pseudo state, or emirate, within the United Arab Emirates) almost defaulted on several billion dollars of debt and caused the global equity markets to drop 3% almost overnight.

But how much more would equity markets get spooked if a larger, more mainstream state defaulted? 

The credit default swap market tracks the risk of such defaults.  And the signs are ominous.  Near the top of the “most likely to default” list are Ukraine, Latvia, Venezuela, Argentina, Pakistan and Greece.

And last week, Greece made the most headlines with its sovereign debt downgrades.  Greece is on a clear road to fiscal disaster.  With only a few months to put its fiscal house in order, it’s highly unlikely that a solution will be found.

And as the Dubai crisis taught us, the next sovereign crisis can come from the most unsuspected places.  If Greece, or any one of more than a dozen nations, implodes, the impact could be Dubai times five or even ten.

Pay close attention to sparks.  The explosion could be devastating.

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