No QE3….Yet

August 27, 2011

Despite a boatload of more bad news, the stock markets rallied last week, with the S&P500 rising 4.7%. Volatility, as would be expected, eased.  But volume also eased, which suggests—strongly—that a wave of new buyers did NOT come rushing in to drive this rally. Instead, for now, it was most likely a technical rally powered by high frequency trading and other sources of high powered money.  The average investor was, and still is, watching the fireworks from the sidelines.  And that’s a wise move.

The bad news was kicked off by the new home sales report, which plunged, instead of rising as expected. The Richmond Fed survey did the same–it fell hard.  While headline durable goods orders rose a respectable 4.0%, they fell 1.5% when the noisy defense and transportation orders were removed. Initial jobless claims also surged much more than expected, this time all the way to 417,000.  Second quarter GDP growth was revised down to 1.0%….again worse than expected.  And finally, consumer sentiment also came in below the already dismal consensus.

Technically, although the S&P is still in a downtrend, it’s coiling itself up for a bigger move, either up or down.  And since a massive down leg has just been completed, it would be very reasonable to see a reasonably strong bounce up over the next couple of weeks, but the bounce would very likely not recoup all the losses from the early May highs.  This bounce would run into some strong overhead resistance in the 1,250 range, suggesting that another 5%-7% would be a safe estimate.

So what happens after the bounce? And how does Bernanke’s “no QE3” announcement play into this?

Here’s a possible scenario:

The credit markets, especially among banks, in the Eurozone are very stressed.  Essentially they are broken.  So euro funding is now being met—as a last resort—by the European Central Bank.  But they’ve announced that they will limit their funding of banks, who in turn buy up shaky PIIGS government debt, until the healthy core sovereigns boost their financial stability fund (think of it as a Euroland TARP) at the end of September or early October.

The problem is that these core nations (think Germany) have indicated that they will not be able to provide more funds from the fiscal side, due to popular resistance in their home nations.  So the euro funding is about to hit a wall.

Adding to this stress is the fact that dollar funding in Euroland is also running dry.  Since many loans in Europe were funded in dollars, and if they can’t be rolled over (think US money market funds saying “no mas”), stresses over the lack of dollars could also erupt shortly.

Finally, the Fed said nothing about QE at Jackson Hole.  Unlike the 2010 speech, this one did NOT strongly hint at another round of credit easing through asset purchases by the Fed.

Put it all together, and what do you get?

A looming credit crisis, erupting in Europe, and migrating to the US, and then to the rest of the world—all at a time when the world’s leading economies are severely slowing, if not entering into outright recessions.

So after a healthy bounce, if this credit crisis ignites in late September or early October, risk markets could resume the strong downtrend that reared its ugly head in August.

The S&P500 would then tumble well below 1,100 and perhaps even cross below 1,000……with the collapse being arrested only when Ben Bernanke rides to the rescue……with QE3 for the US markets and hundreds of billions of dollars in swap lines (loans) for Europe via the ECB.

Then we rally.  Perhaps for several months, with the S&P rising a  good 20% or more.

But after that, sometime in 2012, the real fireworks will begin.  And this show will be awe-inspiring!

Hello Bear Market?

August 20, 2011

For the fifth week in a row, the S&P500 fell, this time by another 4.7%. Volume was high, adding conviction to the price drop.  Volatility, a measure of fear, surged by another 18%, rising to extremely high levels when compared to the prior three years.  Tensions are rising, and from these levels, chances are high that the S&P will either bounce up strongly, or plunge far lower, perhaps even another 10% or 15% from here.

Last week’s macro scorecard was decidedly negative.  The Empire State manufacturing survey fell hard, when it was expected to rise. Housing starts and permits were stuck at their near-depression levels. Existing home sales badly disappointed—despite the record low home mortgage interest rates.  The single high note of the week was industrial production, which rose more than expected. Producer and consumer prices were—across the board—higher than expected; higher inflation will hurt households and corporations alike.  Initial jobless claims jumped back up into the 400,000 range usually associated with recessions.  Finally, there were two shockers last week:  First, the Philly Fed survey literally collapsed.  Instead of rising as predicted, it plunged to its lowest level since the depths of the recession in March 2009.  Second, the US 10 year Treasury rate collapsed to under 2.0%, a rate not seen in about 60 years.  Most economists agree that such a low rate is signalling the onset of a severe economic slowdown, if not a severe recession.

Technically, the S&P500 is broken.  The damage done over the last few weeks far exceeds that of 2010. In fact, the signals on both the daily and weekly charts are now hinting that a new bear market is about to begin.  Officially defined as a drop of 20% or more from peak, a bear market is now only 2% in losses (from the May high) away.

So what are the key events that could trigger further losses over the next few weeks?

Barring some unforeseen Black Swan event, two major events stand out.

First, is the Jackson Hole speech given by Ben Bernanke next Friday. Markets have been trained to expect gifts from Ben Bernanke when the going gets tough.  Why?  Because he, and his predecessor Alan Greenspan, have pretty much always delivered in the past when markets were faltering.  So given this history, the stock markets have already priced in some sort of stimulus from Bernanke.  Whether he pre-announces QE3 (as he did last year with QE2) or some variation of it, markets would take off if he hints that the Fed is prepared to super-size its balance sheet (ie. print billions of dollars more to pump into the markets).  But, should Bernanke not announce this, chances are high that markets will tank.  They will reprice by removing the anticipated stimulus and by pricing in a Fed that will be signalling that the “markets are on their own”.

Second, is the growing debt crisis in Europe.  This crisis is now spreading quickly to major “too-big-to-fail” banks in France (eg. SocGen) and Italy (eg. Intesa) because of their diminished ability to fund themselves with short-term financing (often dollar-based, not euro-based), a problem that in part stems from their unrealized losses on their holdings of PIIGS sovereign debt. These financial institutions are “on fire” and if they blow up, their demise could be more devastating to the global financial order than was the bankruptcy of Lehman Brothers in 2008.  Some experts argue that if banks such as SocGen were to fail, a global depression would be only the start of our problems. So the ECB—perhaps with secret back-door help from the Federal Reserve—will try to keep this fire contained.  If it continues to spread, or heaven forbid, gets out of control, then the markets would not only drop, they would be at risk of collapse……a collapse that could easily exceed the plunge in the fall of 2008.

So all eyes will be on the Fed next week, and Euroland every day for some time to come.  The US and global economies are on the verge of falling into another severe recession.  Stock markets are on the verge of collapse.

Tensions are high.  It won’t take much to trigger another global financial crisis.

In the past, we advised folks to buckle up.  This time, we recommend you put on your helmets.

What if Markets Lose Faith in the Fed?

August 14, 2011

After one of the most tumultuous weeks in the stock markets (ever), the S&P500 managed to close down only 1.7%, after being down momentarily over 8% during the week.  Volatility jumped up again, this time 14%, but after touching multi-year highs during the week.  Volume surged, adding conviction to the direction of the price movement—down.

The economic data were generally negative.  The US trade deficit rose far more than expected; this will hit economic growth results for Q2 of this year.  While jobless claims dipped slightly below 400,000, they will almost surely be revised higher, as they have been virtually 100% of the time (how does that happen…..if the error is random?), next week.  Retail sales disappointed, as did business inventory build rates.  The highlight of the week was consumer sentiment, which literally collapsed down to levels last seen in 1980.  And since consumers make up 70% of the US economy, this does not bode well for future growth, if any.

Technically, the S&P is very oversold on a day-to-day basis.  In fact, by the end of the week, it started showing signs of making a short-term bottom and the makings of a bounce.  This bounce could last for several weeks and could cause the index to rise by 5% to 10%, but this would not break the overall downtrend that the S&P has established over the last month and a half.  Ominously, the 50 day moving average has finally crossed below the 200 day moving average, which is also known as the “Death Cross”.  While by no means a certainty, the odds of continued selling go up because other market analysts may decide to pull back on equity exposure as a result of this technical development.  In other words, another headwind for a sustained rise in market prices has been created.

So what will determine—on a fundamental basis—the direction of stock markets for the rest of the year?

As mentioned in prior posts, two major forces stand out.  First, is the fire that’s burning in Euroland. After getting hit by the news of Italy’s credit market stress (and after the ECB sent a fire brigade to manage this fire), the eurozone was hit with a new blow—emerging stress in France.  France’s major banks sold off badly last week, in some cases losing as much as 20% of their market value.  And this also put pressure on France’s sovereign credit which became more expensive relative to the European benchmark—German government bonds.

While the Euroland solutions, so far, have been nothing but fancy BandAids, they have over the last year and a half been able to kick the can down the road for months at a time.  So there’s good reason to believe that the European elites could plausibly buy several month’s (if not half a year’s) worth of time.  And during this time, most market participants would go back into Risk-On mode, bidding up the euro and global stocks in general, including the S&P.

But the second force could make or break the markets over the next several weeks.  And this is the policy response of the Federal Reserve.  Last August, when the last Death Cross just took effect, the Fed saved the day by pre-announcing QE2 at the Jackson Hole economic conference.  One year later, many market participants—having been conditioned by the Fed to always expect a rescue plan—are now beginning to price in another “surprise” announcement at this year’s Jackson Hole conference which begins in a couple of weeks.

So these investors and traders have begun to bid up the S&P (from its intra-week lows) in anticipation of some sort of QE3, or a variant of it.

But there are two major risks here. One, what if the Fed doesn’t come through this time? What if the Fed tells the markets that they’re on their own for a while?

Answer:  markets would go into a tailspin.

Two, what if markets begin to doubt the efficacy of the Fed’s QE medicine?  After all, it’s becoming obvious to anyone with half a brain that as soon as the Fed’s sugar highs wear off, the markets begin to plummet.  The markets, being so famously forward-looking, may begin to see through another QE program and price in the withdrawal of stimulus soon after it’s announced.  And what happens then?

Answer:  markets would go into a tailspin.

Once again, it’s becoming clear that the Fed is approaching the end game.  It is running out of bullets. While markets in the past trusted the Fed to always pull another rabbit out of its hat, the time is soon approaching when the markets will lose trust in the Fed.

What happens then?

Answer:  all hell breaks loose.


August 6, 2011

KaBoom could even be an understatement. Why?  Because after something collapses, it’s normal to expect that the danger is over and the healing process will follow.

After this week’s market debacle, it’s very probable there’s more pain to come.  The S&P500 dropped almost a hundred points last week, which is a 7.2% decline.  This is the largest weekly decline since the meltdown in March 2009.  Confirming the price collapse was the massive surge in volume.  Investors were desperately selling and seeking to avoid further damage.  Also confirming the sell-off was the spike in the VIX, which jumped almost 30%.

What was the catalyst for the drop?  Per last week’s list of triggers, it was the first item on the list—stress in Euroland.  As stated last week:  “if Italy and Spain keep falling, then look for an ugly reaction in risk assets globally.”

In a nutshell, that’s precisely what happened.  Growing stress in Euroland sparked fear of a global economic slowdown, and more immediately, a global financial credit crunch.  Put the two together and you get a huge sell off in risk assets, especially stocks.

The flow of ugly macro data continued to grow.  ISM manufacturing and services both badly disappointed. Personal spending and income were also lower than predicted. Initial jobless claims, as predicted here, crept back up into the recession-zone, or the 400,000+ range.  While more jobs were created in the headline jobs report, the overall picture was still very grim.  The only reason the unemployment rate ticked down was that a huge number of unemployed folks simply dropped out of the labor force, while the actual number of not working people rose! More non-working people were simply not classified as unemployed any more, so this made the unemployment number look like it improved.

Instead, the opposite is happening.  And two measures clearly capture the horrific employment situation in the US today.  First, the employment -population ratio fell again, now to a 25 year low. Second, the labor force participation rate fell, also to a 25+ year low.

Technically, the stock markets are badly damaged.  Most importantly, the S&P has closed for several days well below the 200 day moving average.  Its’ very likely that next week, the 50 day moving average will cross under the 200 day.  Known as the “Death Cross”, this will signal to a lot of market analysts that more selling is coming, so they advise clients to sell, which leads to a self-fulfilling prophecy……of more selling.

That said, the stock markets are very oversold.  As such, they’re due for at least some sort of modest bounce, but one that’s highly unlikely to lead to new highs over the next two months.

Two final points.

1. This blog for many months this year has been pounding the table arguing that the melt-up in stock prices since September 2010 was almost perfectly tied to the Fed’s QE2 program.  So when the program ends (June 30), we argued that the odds of stock market declines would rise dramatically.

Well, the test is over and the score, as of now, is a perfect 100%. Since July 1, the stock markets have pretty much been going DOWN every week.  Specifically, they finished last week down 11% since QE2 was shut down.  Not bad.

2. The pain is far from over.  Last night, after the market meltdown was history, the United States was downgraded by Standard & Poor’s. For the first time ever, the US is no longer a AAA credit. This is bad news, and will almost certainly scare risk asset markets even more.

And let’s remember, QE3 is not around the corner; Euroland problems are only growing; and all the other potential negative catalysts are still lurking out there.

The bottom line—while the damage to date has been notable, the damage to come….perhaps over the next 60 days….could be far more notable.

Prepare for the possibility of a bigger Kaboom!