Deathwatch in Euroland

The S&P500 inched up about 1% last week, all of that net gain coming on Friday alone.  Volume was moderate, and volatility edged up about 11%.

Economic news mostly negative.  The Empire State Manufacturing Survey was much worse than expected.  Producer prices rose more than predicted.  Consumer prices were in line.  Housing starts rose, but not because single family home starts beat expectations; instead, the entire beat came from apartment starts. Housing permits disappointed.  Initial jobless claims stayed above the critical 400,000 recessionary threshold.  Existing home sales fell more than expected; median home prices fell 3.5% year-over-year. While the Philly Fed beat expectations, Leading Indicators missed.

Technically, the S&P500 is very over bought on the daily charts.  Even a moderate pullback seems very overdue.  On the weekly charts, the S&P’s downtrend is still intact. In fact, as mentioned here several weeks ago, the S&P could rise above 1,300 without violating the downtrend that began in late April.

So what’s going on?

Two of the formerly detailed forces are still in effect:

1. The US and global recession, which seemed like it was about to arrive, could be delayed, slightly at best.  But that delay is enough to offer the Wall Street shills ammunition to argue that perhaps no recession will arrive.  That’s wrong.  But in the meantime, this glimmer of hope helps push stocks higher.

2. The deathwatch in Euroland is not hitting home the way it did a few short weeks ago.  Make no mistake, Euroland is a terminal.  If Greece was the fuse, Spain and Italy will be the actual bombs that blow up the entire currency project. And last week alone, Italian and Spanish government bond yields continued to creep higher and higher. Since together, these two states have about $2 trillion in sovereign debt, a further rise in yields will—-without a doubt—destroy the euro zone, because there simply IS NOT enough money, public or private, available to fund these sums if the credit markets abandon Spain and Italy.  The jump in yields is a sign that the run is already happening, slowly. Meanwhile, silly claims that European leaders are planning to craft plans to “solve” this debt problem were, amazingly, enough for the equity markets to push prices higher.

3. The new twist comes from the Fed.  At the end of the week, two Fed governors made speeches that strongly hinted that the Fed was ready to launch QE3 if conditions required it.  Since the equity markets have already bounced up substantially over the last two weeks, and since inflation is running higher than the Fed’s well-known policy target level, the Fed would likely need to see more “damage” in the markets or in the real economy before launching another round of money creation to buy securities.  But once again, fast traders and algorithms jumped on this message as a sign to buy, buy, buy.

A plausible scenario goes as follows:

Over the next two months, the recessionary forces will reassert themselves, driving estimates of future corporate profits down.  This will begin another wave of stock price sell-offs, perhaps in a reasonably orderly manner.

Then, if Greece does hard default, or a more serious escalation of panic develops in Spain, Italy or even France, a disorderly panic sell-off could add to the existing price erosion, price erosion arising from the developing recession.

Finally, after the markets get hit badly enough, Ben Bernanke will formally announce QE3, perhaps in conjunction with European Central Bank (BoE, BoJ) credit programs.  This will arrest the free fall, and deliver another multi-month rebound in stocks and other risk assets.

Will this be the end of all the risk, all the problems, etc.? Of course not.

But it could kick the can down the road for another six months or so. And then the root problems will rear their ugly heads again, leading the next phase in the ongoing global financial crisis.

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