By
Kevin
Flynn
:
There are three broad currents for the markets to deal with
during the remainder of August. Due to vacations and low
participation, August tends to be a trader's market that can detach
from the real economy more than any other month. Take note as well
that the trader's August actually runs until shortly after Labor
Day weekend.
The current move upward in the market has been easy enough to
understand, despite media attempts to dramatize it and the usual
book-talking from traders and managers. This is the monthly light
week for data, and the rule of thumb for the light week that
happens once every month is that the markets keep going in whatever
direction they left off with at the end of the previous week. A
dramatic surprise will throw it off, as it can any week, but we
really don't get that many that come out of the blue - usually
surprises come from unexpected results from scheduled events.
You can look for this trend to wear out by next Tuesday, when
the July retail sales report is due. Not that we're necessarily
predicting a lemon, but the economic calendar gets busy from that
point on. Markets won't simply keep floating up on low volume
anymore, but go back to reacting to actual reports. The bar should
be higher by then.
As we move into the end of the month, there should be another
calendar current, in this case an attempt to revive prices again.
We call it the "silly season," a name inspired by the professional
golf calendar. It usually lasts a week or two and runs from
somewhere in late August until after Labor Day. We had ourselves a
nice little silly-season rally in August of 2008, for example,
despite being smack in the middle of a recession and warning signs
everywhere that the financial system was about to crack. The Fed
was going to save us, you see, which sounds a lot like this year's
thinking (and every other late August period looking for an excuse
to go higher).
The third current is that mid-August sell-offs are common. With
the July data unlikely to impress next week and a clearly weakening
corporate earnings environment, the odds look fairly good for a
repetition. The principal chance for avoiding it this year might
have been the low expectations that we had only ten days ago, but
bullish sentiment has risen sharply since then, perhaps
excessively, as
Mark Hulbert warned
.
The wild card in all of this - and this year it's something not
to be taken lightly - is what may come out of Europe. It's quite
unusual for anything to happen in the European August, as that is
the premier family vacation time of the year and most leaders are
indeed off on holiday. A low-volume, unsuspecting market is
arguably an excellent time for European Central Bank (ECB)
president Mario Draghi to come in with guns blazing and scare the
daylights out of those short any European instrument, be it stocks,
bonds or the currency.
Whether or not he does it is the question of the month, even the
year. Our belief remains that only a crisis will pull the
ever-widening European rift back together again in concerted
action, but it's possible that Draghi could pull off a surprise
coup and present leaders with a fait accompli when they come back
from vacation. Some may indeed prefer just such an outcome,
allowing the ECB to take the heat while they bluster and huff to
unhappy domestic voters.
There is a dual paradox in all of this. The first is that as the
markets rise on the hope for action, they simultaneously remove the
case for it. With the recent rallies in equities and bond yields,
both Mr. Bernanke and Mr. Draghi have less of a market case for
launching new accommodation measures. A typical August would leave
the major indices fairly close to where they are now, first selling
off and then rallying again as the silly season takes hold and the
promise of more central bank meetings draws near. It will be very
difficult for the Fed to launch new programs next month if the
S&P is still sitting near the levels it's at now.
It isn't unusual for markets to do the work of the central
banks; indeed the latter often count on it. In the case of Europe,
though, central bank action simply isn't going to be enough to
repair a fractured system. The ECB may in the end find a pretext
for buying sovereign bonds, but monetary policy is best suited for
treating monetary problems. Bond-buying isn't going to solve the
larger problem of masses of essentially unrepayable loans that grow
larger with every month of the deepening recession.
Nor would it solve the problem of needed competitive adjustment,
as many of the EU countries require competitive restructuring. It
could come quickly from a devalued currency, slowly from a
restructured economic environment, or somewhere in between from a
combination of the two. Yet a devalued currency, alone or in
combination, seems very unlikely to come about without a major
crisis occurring first, while a restructured economic environment
leading to more competitive European products will happen too
slowly to stop the current recession from worsening
significantly.
The second paradox is that despite the ECB's inability to fix
either the European economy or its competitive position -
theoretically it could devalue the euro, but that would surely
cause a breakup of the currency zone - the financial markets
may very well act as if it can
, in particular the equity markets. Markets have often rallied
right to the edge of the cliff on the prospect of more central bank
easing - and then fallen off.
Similarly, the Fed can do little more either. What the U.S.
needs most right now is a recovering global economy, above all for
Europe to get better, something that is out of the Fed's hands. US
data would have to be quite weak at this point for the Fed to act
independently of Europe's problems, leading to a strong sell-off
first before any rally (no sell-off, no Fed action). But Fed policy
would have little effect on the lack of demand plaguing the US, and
would likely be followed by data that mostly grew weaker before it
got stronger.
The fiscal cliff, a currency too expensive for the troubled EU
countries (though a gift for Germany), the severe Midwestern
drought, China's property bubble, the need for debt restructuring
and competitive restructuring in Europe, along with an end to its
austerity programs - none of these can be solved by central bank
action. But the markets would nevertheless pretend otherwise, at
least for a time. Therein lies the danger for both money managers
and investors: Ignore the rally and you may lose your clients;
invest with it and you may lose your capital. Crashes come only
from a height, and not even the traders get out in time.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
See also
Spectacular Small-Cap Surges Suggest Sentiment
Shift
on seekingalpha.com