Finally, the S&P500 showed some signs of stress. The index fell 2.5% last week on rising–and thus confirming–volume. Also confirming the move was a 33% surge in the VIX index. Market traders suddenly bought a lot of insurance to protect against a further downside move in equity prices.
The economic data were mixed. Consumer confidence rose, even though most of the reason behind the rise was the increase in stock prices. Initial jobless claims were slightly worse than expected; and at 448,000 they are stubbornly remaining in a range that is associated with recessions–anything above 400,000. First quarter 2010 GDP (the first of several readings), at 3.2%,was slightly below expectations; and half of this growth came from inventory building, not final demand growth. Also, it is significantly lower than Q409’s final reading of 5.6%, suggesting that the government-generated economic rebound is rapidly slowing. Both the Chicago PMI and Consumer Sentiment came in above expectations.
Technically, the S&P is still in extremely overbought territory–despite the 2.5% retreat. This is especially the case on the weekly charts. On the daily charts, the S&P has turned bearish. It’s pointing down and a total pullback of 5%-10% is the least that can be expected to unfold over the next several weeks. Such a correction would only bring down the overbought indicators to a more neutral level.
What was the spark that led to last week’s decline?
Simple. Greece will default on its sovereign debt.
To be polite, politicians may not call it a default; a restructuring would be a less distasteful term. And Greece may not default next week or even next month; still, at some point in the future, it will.
Last week, the inevitability of a Greek default started–and only started–to sink in. Harvard economist and Ronald Reagan’s Council of Economic Advisors Chairman Martin Feldstein stated the obvious: “there simply is no way around the arithmetic implied by the scale of deficit reduction and the accompanying economic decline; Greece’s default on its debt is inevitable. In the end, Greece, the eurozone’s other members, and Greece’s creditors will have to accept that the country is insolvent and cannot service its existing debt. At that point, Greece will default.”
But the real source of concern isn’t merely the issue of Greece’s credit risk; Greece, after all, makes up only about 2% of the Eurozone’s total GDP.
The real source of concern–and eventual source of panic–is the threat of contagion. Even before Greece actually defaults, the risk that other PIIGS (and their banks) could also default will grow. In fact, judging by their surging interest rates, the risk of contagion is already growing.
This means that as Greece topples, Portugal, Spain, Italy, Ireland, and then eventually the UK will also face the strong possibility of “restructuring” their debts.
This could be the next Lehman moment. Markets–in almost all asset classes–would sell off sharply. The US dollar and US government debt would probably rally.
Time to order the popcorn and enjoy the show.