The S&P500 managed to lose only 0.24% last week. Volatility crept higher, suggesting that concerns against greater losses were being priced in. Volume, as has been typical over the last two years, was very low and trending lower (ie. the first quarter’s volume was notably lower  than volume in the first quarter of 2012). And this flies in the face of everyone on mainstream media touting how the small retail investor was ‘coming back’ to the stock market and ‘rotating’ out of bonds. If that were true, then equity volumes would be rising, not shrinking. And more importantly, the disappearing volumes imply that the recent price gains have been built on a foundation of quick-sand, and that any  disturbance to the upward momentum, whether it’s Cyprus or anything else, could lead to a quick and vicious sell-off.

In macro news, housing starts disappointed slightly. While the housing ‘recovery’ engineered by the Fed and the Treasury seems to be pushing prices up for now, it’s important to remember that this is not happening because the housing market is recovering organically, and when these government policies are pulled back, the US housing market will very likely begin to struggle once again. Initial jobless claims have been hovering near the mid-300 thousand range for several weeks. Existing home sales, while rising, missed expectations. The Philly Fed survey came in slightly better than expected, as did the leading indicators index, which being driven by the rise in stock prices is arguably a somewhat circular measure (stock prices up, so leading indicators up, so more stock price increases).

Technically, the US stock market continues to be extremely over-bullish and over-bought. History very strongly suggests that at these levels of over-bullishness, even the slightest disturbance could lead stock owners rushing to the exits to avoid losing the substantial paper gains achieved over the last several months. The problem is that history also suggests, strongly, that almost all investors who believe they’ll  be able to ‘get out’ before any real damage hits them are wrong……most will get caught in any severe pullback.

And speaking of pullbacks, it seems that—for now—Cyprus may not be the spark that triggers one. As of this writing, the island nation has apparently struck a deal that would presumably avoid a collapse of its banking system.

But at what cost?

Well for one, many depositors who hold more than 100,ooo euros will suffer massive confiscation of their money. Nobody even knows for sure what the haircut will be, but it mean a loss as high as 40% or even 50% of all balances above 100,000.

Another consequence is the imposition of capital controls, to try to prevent the thousands of depositors who have been burned, and who were almost burned, from withdrawing money from their Cyprus banks accounts. Cash withdrawals have already been restricted, and restrictions on large electronic transfers are sure to follow.

These developments have created a shockwave, not only for depositors in Cyprus banks but depositors in all euro-area periphery nations, also known as the PIIGS.

The psychological damage will be devastating. All of these depositors will rightfully ask, if this damage can happen in Cyprus, why can’t it happen in Spain, Italy, Portugal, etc.?

And the answer is that it most certainly can.

As a result, many will begin to quietly withdraw euros from their accounts in these periphery states, especially folks and businesses with balances above 100,000 euros.

This will most definitely lead to financial stress in the euro area banking system.

So while the future consequences remain to be seen, we can almost guarantee that they will not be good.


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