Sliding to the Cliff’s Edge?

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.

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