What Just Happened with Equities?

The S&P500 soared almost 6% last week, as stocks continued to build on the prior week’s gains.  That’s the good news.  But there’s lot’s of bad news and a lot of head scratching to try to explain what just happened.  For starters, volume was VERY light; this means that new buyers did NOT rush in to buy stocks. In fact, all surveys of retail money flows showed that average investors continued to pull money OUT of stocks.

There’s more to this, but first some macro news.  The trade deficit is still horrible; and with China, it’s near record highs.  Initial jobless claims rose to 404,000 from last week’s 401,000.  Retail sales (excluding autos and gas) met expectations.  Consumer sentiment fell badly; instead of rising to 60.0 as expected, it fell to 57.5.  What’s worse, the “expectations” component fell to 47.0 which is the lowest reading since 1980!

Technically, the S&P on a weekly basis is still in a cyclical bear market, the two week rally notwithstanding. On the daily charts, the S&P is severely over bought.  It is very ripe for a pullback.

What could spark such a pullback?  Well, it could be tied to the reasons behind the explosive two week surge.

One of the strongest drivers behind investors’ desire to take on more risk—for example, by purchasing equities—is a rise in the value of the euro vs. the US dollar.  The correlation is so strong that many algorithmic computer trading programs use it as a key signal to buy or sell stocks.

The day the stock rally began, the euro surged, and as it did, more programs piled on to buy more stocks and more often, cover short positions in stocks.  Short covering—-as opposed to new money entering to buy—explains why volumes fell as the stock rally gained momentum.

But what could have caused the euro to rally?

According to Deutsche Bank, via Zero Hedge, the European (especially the French) banking system was in full panic mode when the rally began.  It was suffering from a horrible funding run, where existing funding sources were refusing to continue lending.

As a result, these banks were being forced to sell assets, and since European asset prices were so depressed, these banks sold assets that held the most in the world at the time—US dollar assets.

And to bring these dollars back home to pay off departing lenders, the banks had to convert these dollars into Euros.

The result?

The euro goes up. The dollar falls.

And just like that, a huge BUY stocks signal is generated.  The global trading robots take over, and a massive rally “comes out of nowhere”.

Meanwhile, don’t forget, the European banking system is in panic mode.  The evidence? French bond yields were surging, especially against the German 10 year Bund.  Other core European credit markets kept on deteriorating.  And critically important Spanish and Italian government bond yields were blowing out as well, with Italian yields nearing the catastrophic 6% threshold once again.

The world was fooled.

The world began to falsely believe that the European debt crisis is on the road to healing (it isn’t) , and that THIS wast he reason behind the rally.

Instead, the real reason could have been the OPPOSITE.  The European banking system is falling apart and as a result, inadvertently caused the US dollar to fall as it tried to save itself from imploding.

As Zero Hedge points out, once the world understands what just happened, the entire bounce could reverse itself in a matter of days.

Nothing has been fixed.  Nothing can be fixed, anytime soon.

Stocks are extremely vulnerable to a violent correction.

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