Scenario for Next 12-24 Months

September 24, 2011

The S&P500 fell apart last week, precise for the reason outlined last week:

 “….there is no good reason why this bounce must come to an end anytime soon.

Except for one thing—the Fed and its meeting announcement this upcoming week.

Because risk markets have risen in reaction to central bank actions and promises, they have already priced in a continuation of liquidity support by the Fed.  This means that for the bounce to hold—never mind continue higher—the Fed must come through with a strong dose of medicine at its announcement.

If so, the bounce will hold and even continue higher…..to say 1,300.

If not, then the bounce will most likely reverse itself……quickly…..to say 1,150 or lower.”

The failed to “come through” and did NOT pleasantly surprise the market with more quantitative easing (ie. an expansion of its balance sheet by creating more money).

And as predicted, the S&P  fell to “1,150 or lower”……specifically: 1,136. This was a painful 6.5% drop on rising volume, which added more validity to the fall.  Volatility spiked 33%, and the breadth of the decline was very wide, meaning that most stocks in the indices fell along with the market.

There were only a few macro news releases, mostly bad.  Housing starts were lower than expected. Existing home sales beat expectations, BUT the median price fell another 5.1% yoy. Initial jobless claims were higher than forecast, and leading indicators were slightly better (but this had more to do with lower interest rates which are obviously manipulated down by the Fed).

Technically, the down trend has re-asserted itself on the daily charts. Once the S&P drops below 1,100 it will have fallen by 20% from the early May high.  This will then become an official cyclical bear market. On the weekly charts, the down trend that began in the spring had never ended—last week’s bounce did nothing to challenge it.

So what can we expect going forward in the US equity markets?

While is always impossible to forecast with any great certainty, it is useful to think about possible scenarios.

And here is one that could play out over the next 12-24 months:

We’re currently in a secular bear market that began after the 2000 tech crash.  Within this secular bear, we’ve had two cyclical bull markets: 2003-07 and 2009-11.
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It looks like we’ll break through the August 2011 lows, to somewhere around the July 2010 lows near 1,000 (where there should be a LOT of support, technically, and because Europe could come up with one last BandAid bailout program).  Then, with everyone caught on one side of the boat (short), the S&P rallies to 1250-1300, which would not break the downtrend that began after the May 2011 high.
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Then, if Greece blows up (or if we see any similar Euroland heart attack), we go back down…..through the July 2010 lows, sometime in 2012.  With the S&P in the low 900’s and with little technical support preventing more damage, the central banks money printing (think QE3 that didn’t happen last week) will kick in.
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THIS should be the Fed’s last stand.  And unless the fundamental issues (excessive and bad credit…..at banks and sovereigns around the world) are fixed—and let’s face it, they CAN’T be fixed without huge PAIN in the social/economic system, so therefore political short-termism means it WON’T be properly fixed—we go down toward the true secular lows…..sometime in 2013 or 2014.

Sure this is only speculation, but it’s very plausible and it’s tied into the major global macro theme that’s been driving the markets since the beginning of the secular bear after 2000

What’s NOT speculation is this—the secular bear market is far from over. Exactly what path it takes over the next 12-24 months is open for debate. But there’s very little doubt that there’s much more pain ahead in equity markets….in the US and around the world.

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Up Next….The Fed

September 17, 2011

Well it finally happened—the much anticipated bounce.  The S&P500 jumped 5.35% last week on reasonably strong volume, but much of this volume was NOT comprised of suddenly enthusiastic buyers (retail investors are still pulling money out in droves). Rather, it had more to do with professional traders covering their short positions (which requires them to buy stocks).  Not surprisingly, volatility also dropped quite a bit, as folks who previously bought options to hedge against further downside risks reversed these hedges.

On the economic front, nothing that would argue against the onset of a new recession emerged. Import prices spiked much more than expected; this cuts into corporate profits.  Similarly, producer prices were higher than expected.  On the consumer front, retail sales (headline and excluding autos) were flat; they were supposed to rise. Consumer prices also rose more than expected.  The Empire State manufacturing survey was supposed to improve; it got worse. Unemployment claims spiked up back into the mid-400,000 range which is solidly in recession territory.  The Philly Fed survey was worse than expected.  And consumer sentiment, while slightly better than expected, came in a the worst level since February 2009.

All in all, consumers (by far the largest segment of the US economy) are losing more jobs, paying higher prices and spending less at stores. Meanwhile, corporations are selling less stuff, paying more for their goods, and staring at profit margin squeezes in the near future.

Technically, here’s what we said last week:

If the S&P drops another couple of percent next week, even the daily charts will revert to a bearish status.  On the other hand, if the S&P finds its footing, it could rise all the way back up to 1,300 without breaking the downtrend that’s established on the weekly charts.

And last week, this second scenario played out—the S&P found its footing and rallied, in the face of all the horrible economic data.   The main reason was that the world’s major central banks got together and agreed to make available hundreds of billions of US dollars to troubled borrowers in Europe.

Does this solve the Euroland debt woes?  Not a chance.  But it does buy time, and when combined with even MORE dollar liquidity, risk markets tend to go up.

Will this rally last for a long time? It’s doubtful, mainly again, because the underlying debt rot has not been removed.  But per the scenario outlined last week here, the S&P could continue to bounce for a another 5+% (up to 1,300) before running into stiff resistance.  In other words, there is no good reason why this bounce must come to an end anytime soon.

Except for one thing—the Fed and its meeting announcement this upcoming week.

Because risk markets have risen in reaction to central bank actions and promises, they have already priced in a continuation of liquidity support by the Fed.  This means that for the bounce to hold—never mind continue higher—the Fed must come through with a strong dose of medicine at its announcement.

If so, the bounce will hold and even continue higher…..to say 1,300.

If not, then the bounce will most likely reverse itself……quickly…..to say 1,150 or lower.

So today’s markets are walking on eggshells.  As Euroland risks blowing up on a daily basis, the rest of the world is sliding into another recession.  And the US Congress is about to slash fiscal stimulus (via its debt commission) and join the austerity march that much of Western Europe has already started.

That pretty much leaves the world’s central banks—led by the Fed—as the last resort tool to prop up the equity markets.  And even if the Fed whips out another rabbit out of its hat this week, it will keep the charade going for only a short while longer.

Because unless the Fed can “print” corporate earnings and create a miraculous “fix” for the solvency crisis in Europe, the stock markets of the world WILL come down.  Earnings will plunge and a relatively stable P/E ratio will force prices to fall.


Sliding to the Cliff’s Edge?

September 10, 2011

Another week, another loss.  This time the S&P500 slid almost 1.7% on robust volume, although the week was shortened by the Labor Day holiday.  Volatility jumped, although not to the levels reached during the early August panic sell-off.  One piece of good news is that the S&P has not fallen into a bear market, usually triggered when it falls 20% or more from its most recent peak.  From the highs of early May, the S&P is now down only 16%.  The bad news is that most of the major European markets have fallen by much more than 20%, and that bodes ill for the US.

There wasn’t much in the way of economic news last week.  The ISM services index came in slightly better than expected, as did international trade, which meant that the trade deficit wasn’t as bad as predicted.  Initial jobless claims crept higher, this time to 414,000 which was an increase over the previous week (and this continues the streak of 400,000+ string of reports that are strongly associated with recessions).

Technically, the S&P500 is firmly in a downtrend, when viewed on the weekly charts.  A variety of momentum and breadth indicators also support this bearish trend.  What’s worse, this downtrend shows no signs of abating, unlike the less severe downturn from mid-2010 which had begun to reverse only four months after it started.  On the daily charts,  the bounce that began a couple of weeks ago—while still intact—looks like it’s on the verge of breaking down.  If the S&P drops another couple of percent next week, even the daily charts will revert to a bearish status.  On the other hand, if the S&P finds its footing, it could rise all the way back up to 1,300 without breaking the downtrend that’s established on the weekly charts.

So given the light macro news week in the US, what caused the equity markets to resume their down swing?

Exactly as predicted, the growing problems in Euroland spooked all risk markets, especially stocks. This time it was the threat of an imminent default, a hard default, in Greece.  Although “authorities” in Greece and the European leadership rushed to deny these rumors, the markets didn’t believe them.

Instead, investors turned their attention to Greek government debt markets, which aren’t capable of lying.  As of last week, Greek 10 year bonds yielded almost 21% and the Greek 1 year notes yielded almost 100%.  That’s right, 100%!  How?  Simple.  You buy a note for 50 cents on the dollar (at half of par value) and would look to get repaid at par (100) in a year.  So 50 cents of return for your 50 cents of investment (the small interest payment is almost immaterial) results in a yield of 100%.

But that’s IF you get paid your par value in a year.

Clearly, the market is pricing in a high probability that you won’t.  How high?  Well, with a 100% yield on a one year note, the implied probability of default is almost 100%.

So the markets are simply waiting for the time WHEN Greece defaults. Nobody is wondering IF Greece will default.

But there are even more problems beyond Greece. Italian government bond yields started ramping higher again.  The leading German member of the European Central Bank—without any warning—quit his post three years before he was scheduled to step down.  The German constitutional court ruling, while not outlawing Germany’s participation in the EFSF, made future bailouts far more cumbersome and unlikely. Also, major German and French banks started to melt down; many have lost 30%-50% of their equity values over the last 30 days, as investors price in the massive losses that they would incur after Greece (or any other PIIGS state) defaults.

And the list doesn’t end there.

The point is that the European situation now appears to be on the edge of disaster.  And any number of catalysts could provide the final “push” that sends the entire Euro system over the edge.

And when that happens, US equities will take a beating.   We’ll see many other grim side effects too, but at least we can safely say that stocks will be cheaper…….much cheaper.


All Eyes on Euroland

September 3, 2011

What a wild ride.  After jumping up about 4.5% in the first three days of the week, the S&P500 closed DOWN 0.24% by the end of trading on Friday.  Volatility, while higher than normal, dipped for the week.  And volume was light, but that probably had more to do with the upcoming Labor Day holiday weekend as investors and traders simply postponed major decisions until everyone returns from vacation in about a week.

The doom and gloom in economic data continued to build.  Pending home sales fell more than expected. Personal incomes were stagnant. While personal spending rose more than expected, much of the rise has to do with unsustainable transfer payments (think unemployment insurance) from the government. Consumer confidence plunged….to the lowest level since April 2009.  Chicago PMI fell month-over-month, but not quite as much as expected.  Initial jobless claims were higher than estimated.  ISM manufacturing fell, but also not quite as much as economists had predicted.  The shocker of the week was the big number, the jobs report for August, which literally collapsed.  Instead of the 70 thousand new jobs that were predicted, the economy generated ZERO jobs.  What’s worse, average hourly earnings fell; they were expected to rise slightly.  The average workweek shrank; it was supposed to hold steady.  This was the worst jobs report in almost a year, and this stunningly bad result sent the US and global markets into the big sell-off on Friday.

Technically, the bounce that began a couple of weeks ago—while not officially over—is showing signs of weakening.  If stock markets shake off Friday’s drubbing and immediately rally at the beginning of next week, then the bounce could continue for a while longer.  The problem is that the weekly charts are still badly broken.  In fact, almost every major indicator is suggesting that the late July and early August crash was the beginning of what could be the next cyclical bear market, almost two and a half years after the last one ended in late March of 2009.  If so, then the psychology of the markets will change.  Instead of buying the dips, traders and investors will learn to sell the rallies. That means that this bounce which began several weeks ago may not have much more room to go.  If selling resumes early next week, then another strong leg down, perhaps to the mid 1,000 range, could begin.

Now that the August jobs report is out of the way, equity investors will not have any game-changing events—in the US—to react to, for several weeks. Sure, they’ll listen to the Obama speech on jobs, but nobody really expects much from it.  And yes, the Fed meets toward the end of the month, but much of the anticipated Fed stimulus (Operation Twist, or otherwise) is already being priced in by the markets; it was the primary catalyst behind the late August bounce.

That leaves Europe.  All eyes will be on the German court ruling (next week) on the legality of the bailout fund.  Others will be looking at the Greek negotiations over their second bailout, negotiations that seem to be breaking down.  Still others will be watching Italy and their rising bond yields as the ECB steps away from buying the bonds and suppressing the yields.  And everyone will be fixated on European inter-bank credit markets to see if one, or more, key bank is on the verge of falling into a funding crisis.  And there’s more.

But the bottom line is that Europe is now a powder-keg with multiple fuses……all of them lit.  Unless the troika—the ECB, the IMF, the EC—can kill each and every one of these fuses, there will very likely be an explosion, a financial explosion that will rock the world and its markets.

The US jobs report was bad. The risk of a new global recession is scary.  The fears of a hard landing in China are real.  But nothing will lop off 30% of the value of global stocks faster than a Euroland contagion.

Yet the odds of such an explosion have never been higher.  It could happen as early as next week, or as soon as next month.  Either way, Euroland does not have, it seems, another six months to live.