When fundamentals are controversial, cloudy, and just plain
confusing, what is an investor to do? Is this a great buying
opportunity or just the beginning of a much longer correction?
The US economic picture looks fair to good, with stable GDP growth
of around 2.5% and steady improvement in manufacturing, housing,
employment, and consumer finance. S&P 500 earnings estimates
currently have the index trading at a very attractive multiple of
13 times 2012 projections (which have come down in the past year
from EPS of over $110 to $103).
But then there's Europe. We know a recession is baked-in for 2012,
but their debt crisis represents a wild card situation where any
day could spark a banking contagion meltdown. As Europeans feel
hostage to Greece, the US feels somewhat captive to all 17
countries comprising the globe's second largest economy at $12
trillion GDP.
The bull market is officially on hold again as we wait for them to
make up their minds about a few things.
It is uncertain times like these that cause me to look at the price
chart of the most important stock index in the world, the S&P
500, to tell me what large investors and asset managers think of
the fundamentals. After surviving a 2011 second half correction
that nearly turned into a bear market in October, US equities shook
off European fears as it became clear that leaders over there would
start to address their crisis and prevent systemic effects.
I was a buyer last fall below S&P 1,200 because I thought the
fears were overblown and Europe would get things right. In a sense,
I over-simplified matters because I saw extreme fundamental and
technical value at S&P 1,100 and I assumed that the European
Central Bank (ECB) would start to act more like our Federal
Reserve.
But the past month has seen a slow revival of fear, as if the
market was pricing-in a coin-flip's chance of Greece falling out of
the euro. And I also realized that Europe's problems are much more
complicated to solve than the ECB simply getting the Fed's religion
of quantitative easing.
A Curious Bull-Bear Stalemate
After finding support below 1,300 and surging above 1,325 early in
the week, the S&P 500 has been swinging back and forth in
knee-jerk reactions over expectations and rumors out of Europe
about if, when, and how Greece might fall out of the Eurozone and
cause a domino effect of banking contagion that could affect the
entire global financial system.
And every day the index closed somewhere between 1,315 and 1,320,
as if it had found an equilibrium level and was merely waiting for
some catalyst to make it move definitely one way or the other. One
of the things the market seems to wait for is confirmation that
Europeans will decide to let their central bank support the
financial system and economy in any conceivable or preventable
disaster scenario with massive quantitative easing. In short, the
world wants to hear a "yes" to these two words: euro bonds.
Wednesday afternoon as the index fell back below 1,300 and the EU
summit dinner meeting was about to begin in Brussels, stocks
suddenly surged in the last hour on comments from French and
Italian leaders that they were prepared to "do whatever it takes"
to stem their crisis. The S&P quickly surged back above 1,315.
Then, following the umpteenth EU summit in the last two years of
their debt crisis, came a sober conclusion from Jean-Claude
Juncker, Luxembourg Prime Minister and President of the finance
ministers of the eurozone known as the Euro Group.
Speaking to reporters, Junker said that joint debt sales "didn't
find much support," particularly in the German-speaking area, while
the French-speaking area was more enthusiastic.
The market did not sell off though dramatically though, at first
making a run for 1,325 and then drifting down to 1,310. Which was
very interesting I thought. Could we be back to the days of the
past six months where sufficient fear about Europe is priced-in? Or
do large investors actually believe that the ECB cavalry is coming
to the rescue?
And then Thursday afternoon became a repeat of Wednesday with late
day statements from European leaders sounding the rally cry. This
time it was Italian PM Mario Monti in an Italian TV interview
essentially refuting Juncker with these words...
"A majority of EU leaders backed the idea of joint euro-area bonds.
Europe can have euro bonds soon."
Reporters ran with this story and interpreted Monti's words as
"Merkel left the door open for euro bonds!"
Read My Lips: "Nein!"
But before US markets could even open Friday morning, word came
that German Chancellor Angela Merkel still had no intention of
talking about issuing centralized debt from the ECB.
"This means very hard work for Europe. It makes no sense to paper
over everything with euro bonds or other instruments that
ostensibly show solidarity, only to find Europe in even more
difficult straits than we are in today."
But as
Bloomberg reports
, there is a lot of discussion lately about an under-the-radar debt
relief proposal that may have markets a little more optimistic
lately...
While she refused to back joint euro-area bonds at a Brussels
summit on May 23, Germany's opposition parties wrung a concession
from the chancellor on her return to Berlin (Thursday) to
reconsider a separate proposal on common liability for sovereign
debt.
The blueprint, published in November by Merkel's council of
economic advisers, involves a so-called European redemption fund
that would help governments scale back outstanding debt to below 60
percent of economic output in return for constitutional commitments
on economic reform. The government and opposition agreed to study
the fund and discuss it further on June 13.
Merkel, who poured cold water on the redemption fund when it was
unveiled last year, again doused joint debt liability in a speech
yesterday, saying that the causes of the debt crisis "can't be
redressed with one big bang.
But, she may allow herself to be forced into compromise. After all,
it is far better to fight and lose on one's principles, then just
to give in to the undisciplined hordes.
This is the simple logic I have used to evaluate the German stance
in the past year:
Germany wins in several scenarios as things melt down. They get
concessions on fiscal austerity and they get a lower euro. And if
they seem like the bad guy letting Athens or Madrid burn to the
ground while they stand by and watch, they don't' care and won't
give in... unless forced to.
Maybe Merkel wants to be forced by events and politics so she
doesn't have to bend and appear to compromise. That is a dangerous
game of chicken. But she is comfortable with that game as we saw
last fall.
What's changing is that the Germans can't run the show forever.
Compromises may be around the corner. But realistically what we
will see is new financial agreements and innovations. Everything --
anything -- but eurobonds.
Low Expectations, Low Fear
The chart and all this news flow tell me two things:
1) Intelligent market participants are not as afraid of Greece
falling out (getting kicked out) of the eurozone as they were in
early May. How do I know? Because the consequences would be so
severe for the European financial system, as all institutions made
emergency adjustments and prepared for systemic fallout. If Greece
were really going, the market would not be holding up so well above
1,300.
Sure, we have to wait and see if Greeks can form a new government
with elections June 17. But I think the market is telling us that
confidence from Merkel and others indicates they will do whatever
is necessary to keep Greece aboard. The price of not getting a
pro-austerity coalition in Greece to cooperate is deemed so great
by major investment houses such as Morgan Stanley, Barclays,
Goldman Sachs, JPMorgan, and Jefferies that the market would surely
be another 10% lower if they thought the worst was coming.
2) Intelligent market participants are not expecting euro bonds any
time soon. They know Merkel and Co. won't go that way -- at least
not this year. The EU and the ECB have a lot of other policy
options up their sleeve before they are forced to capitulate to the
calls for Fed-style QE, to say nothing of the political hurdles
required to change EU and ECB charters and laws.
So what are they expecting and what are they afraid of?
At the risk of over-simplifying again, they are expecting some
measures from European financial leaders before June 17, which
could include the following...
Some form of emergency FDIC-type bank deposit guarantees to prevent
bank runs
An announcement about new plans for a centralized banking system
that can handle/prevent bank failures
Here's ECB Executive Board member Peter Praet speaking at a
conference in Milan Friday...
"Europe needs to move towards a financial union, with a single euro
area authority responsible for the supervision and resolution of
large and complex cross-border banks. Decisive and far-sighted
reforms like these, unrealistic until a short while ago, are now
gaining support. Reacting to the pressure of events may seem
unattractive, but it may also be the only way forward."
According to Reuters, "Praet told the conference that there was 'no
escaping a banking union' and that a resolution framework was an
essential part of a single market."
And what are big market participants afraid of that has them
neither selling nor buying too many stocks at S&P 1,315 and
keeping the bears honest in a very narrow range?
They are still afraid of course that European leaders will continue
to drag their feet and let the crisis grow worse, especially while
the recent Spanish bank failure could be just the tip of the
iceberg there.
And they are probably accepting the reality that even if some
positive news out of Europe next week sparks a rally, we are going
to be in this corrective phase for a while until more certainty is
achieved about Greece and European banking system.
I think the chart above is telling you the market is setting up for
another fear-driven slide lower. It's a classic pattern in many
ways. In the one-month picture you see above, we have this week
looking like a bear flag or rising wedge in the context of the drop
since early May. And we have four consecutive days with a very
narrow range (at least in the candle bodies which represent the
open and close).
Bottom line: Without decisive action out of Europe, rallies will be
hope-filled but short-lived. The summer trading range is likely to
be 1,350 down to 1,250 as Europe rights the ship.
Why not lower? Because right now the market is telling you Europe
will make some necessary adjustments and prevent systemic meltdown.
When price and market behavior say something different, I'll adjust
and let you know.
Kevin Cook is a Senior Stock Strategist with
Zacks.com
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