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!