SAN DIEGO (ETFguide.com) - A 3,600 mile long rope from New York
to Madrid, Spain would fittingly symbolize the tug of war between
the United States and Europe.
Perched on one side of the Atlantic is the S&P 500 Index
(SNP: ^ GSPC), which is barely 15% below its 2007 all-time high and
just saw record high corporate earnings.
Crumbling on the other side of the pond is Spain's IBEX 35,
which trades more than 50% below its 2007 high. But Spain is not
the only weak link in the chain. France's CAC 40 also trades 50%
below its all-time high and even Germany's DAX is off by more than
Even the world wide MSCI EAFE Index (NYSEArca: EFA) is down some
40% since its 2007 high. The chart below compares the S&P
(NYSEArca: SPY) with Spain's IBEX 35.
Such big disparities are unusual, so the key question is whether
the U.S. market will lift up Europe or if Europe will drag down the
U.S. Strength Is Also Its Weakness
Citing corporate earnings, market analysts believe that the U.S.
economy is booming, although 46 million Americans on food stamps
beg to differ.
Various accounting gimmicks - prevalent predominantly in the
financial sector (NYSEArca: XLF), and an extremely accommodative
Federal Reserve, have made corporations less reliant on consumer
Nevertheless, let's assume that corporate earnings are for real,
or at least as real as they were in 2000 and 2007. The chart below
shows record earnings foreshadow market tops like falling leaves
Based on facts and historical patterns, record earnings are net
negative for stocks. In hindsight, this was particularly pronounced
in 2010 and 2011.
Even as the market sculpted the 2011 top, the April 3, 2011 ETF
Profit Strategy update warned that: "A major market top is forming.
S&P 1,369 - 1,382 is a strong candidate for a reversal." Fueled
by better than expected earnings, the S&P briefly squirted to
1,371 and cratered 20% shortly thereafter.
A year earlier the April 16, 2010 ETF Profit Strategy Newsletter
looked at the earnings picture and warned that: "The message
conveyed by the composite bullishness is unmistakably bearish. The
pieces are in place for a major decline." The Flash Crash happened
13 trading days later.
Strong earnings are an asset to the economy, but they are also
one of the stock market's (NYSEArca: VTI) biggest liabilities. Even
in sports, a streak can only last so long before it breaks. The
2012 earnings season is shaping up to be a repeat of recent
Europe - A Pattern of Failure
What comes to mind when you think of June 26, 2009? That's the
date when Greece's Finance Minster announced a tiny budget deficit.
This tiny deficit blossomed into the largest sovereign default in
Below is a small bouquet of headlines that illustrates the
progression of Greece's situation:
December 21, 2009: "ECB member says no bailouts for Greece" -
January 18, 2010: "Two EU ministers: No bailout for Greece" - WSJ
April 24, 2010: "Greece asks for $60 billion bailout" - AP
May 3, 2010: "Greece gets $146 billion rescue package" - Reuters
December 17, 2010: "IMF approves $3.3 billion for Greece amid
impressive fiscal adjustment" - Bloomberg
October 27, 2011: "The debt is absolutely sustainable now. Greece
can settle its accounts from the past now, once and for all" -
Greek Prime Minister
The Greek saga would be humorous if it wasn't so sad. What's the
moral of the story?
We've learned that the European Central Bank (ECB) totally
misjudged the scope of Greece's problems. We've learned that EU
ministers had no clue. We've learned that Greece only needed to ask
for $60 billion to get $146 billion. We've learned that the
International Monetary Fund (
) considered Greece's fiscal adjustment in 2010 impressive and
we've learned that a country in trouble will say anything to get
more money. What reason do we have to think Spain, Portugal or
Italy will be any different?
Based on a rough assessment, I would say Spain, Portugal and
Italy are now about where Greece was two years ago. Instead of
bailouts, they got low interest rate loans. Instead of hundreds of
billions of euro in 2010, the ECB gave a trillion in 2011/12.
Spreading the Virus
Holders of Greek debt only lost about euro100 billion, so why
did the ECB make over euro1 trillion long-term low interest loans
available? The ECB obviously knows that the problem has spread
The ECB is encouraging European banks via the low-interest LTRO
I and LTRO II loans to buy the debt of fiscally morose countries
like Spain, Italy, Portugal, etc. This keeps the bond yields low
and debt manageable for those countries.
But what it doesn't do is quarantine the toxic virus like debt
of Spain, Italy, Portugal, etc. Like any kind of epidemic, wouldn't
it make sense to isolate and kill the problem before it
The amount of toxic government bonds in circulation is billions
(possibly hundreds of billions of dollars) higher than it was when
LTRO I started about six months ago. That means if Spain (or Italy,
or Portugal, or...) goes bust, the damage will be much greater than
it would have been six months ago.
If the pattern of Greece's "deny and defy" approach is any
guidance, Spain and other fiscally lackadaisical will have the same
fate. There's just one minor difference:
Spain and Italy together have an economy that's 11x larger than
Greece. You don't want to be invested when that bomb goes off.
ETF Profit Strategy Newsletter's
goal today - as in 2010 and 2011 - is to issue the kind of warning
that gets investors out of stocks before the next leg down. When
stocks fall, they tend to fall hard, and an ounce of prevention is
worth more than a pound of cure (the Newsletter issued a sell
signal at S&P 1,386).