The Three E’s: Into the Unknown

Europe Is The Only Variable That May Be Close To Playing Out In This Market

U.S. stocks are on the edge of some kind of big move. The real question is which way the move will be and what the catalyst will be.

Looking at the three major themes governing the market these days, the Three E's: Europe, the Election, and the Economy, it's not difficult to figure out that something is going to give, and that when it does, the trend that follows could be in place for some time. Thus, for investors, it's not so much about betting on which way the market will go, but knowing that at some point, likely within the next few weeks and months, a major trend, up or down will develop. When it does, big money making opportunities will likely develop. If we had to bet we would put our money on the possibility that the end game is near for Europe, and that from there the rest of the variables will make their move.

Europe is getting the headlines, and rightly so. The situation in Spain is deteriorating while Greece seems beyond repair at this point. If Spain falls, many new dominoes are likely to fall. It's clear to see from the flow of money out many European nations that the population at large is starting to come closer to the panic point. At that point, however, is when many lifetime opportunities materialize for investors. And that's why we are suggesting that patience, preparation and vigilance are more important than making a big bet and hoping that things go in your favor.

The U.S. economy is a regional affair. Some areas of the country are doing fairly well. But it's highly unpredictable as some areas that are near one another almost seem like they aren't related, geographically or otherwise. On a recent trip to Houston this was obvious. We had an opportunity to travel to many different demographic areas, from the very well to do, to the middle of the road, and slightly below that. What we saw is that the well to do are doing fairly well, while those in other areas of the city are not. This is happening in different counties, and also in different cities all over Texas, where things are going better than in other areas of the country.

This patchy performance makes it more difficult to evaluate the entire economy. We do have some fairly significant travel plans for this summer that will help us to have better observational data. What we can glean from what we've seen, and from general data from the Federal Reserve (Beige Book) and other reports, is that patchy is the best way to describe things in the U.S. The rest of the world is having more trouble. Even rapidly growing economies until recently, China, India, and Brazil are starting to stumble. Europe's problems are well known. And social unrest and bloodshed in the Middle East are running rampant, creating an uneasy mix between politics and the economy.

The U.S. election is becoming increasingly interesting and important. Mitt Romney is starting to eat into President Obama's once seeming invincible lead. And the fact that the economy is failing to lift all boats in any sort of predictable fashion may be adding to the president's increasingly fading chances of re-election. The markets have yet to figure out which way to bet on the possibility of a Romney win. It's just simply too early for that. But, the polls continue to suggest that the election is now too close to call, and that means too close to bet on in a big way. The real question here is whether the structural problems that have made this a tough recovery are more or less important than the confidence crisis that has kept business decision makers from taking chances and hiring new employees at a faster pace.

If you fall on the side of the line that says that structural problems are too deep to fix in the short term, the election may not matter that much. But if you believe that the structural problems won't have a chance to be fixed unless there is a change at the White House, then you have to be more patient as it is likely to take the full five or six months until November to know the truth. If Mr. Romney begins to put some distance between himself and the president, and the market starts to rally, much of this will start to make some sense. Yet, if Mr. Romney becomes the likely winner and there is no rally, it will be clear that the structural camp is getting the belief and things will remain difficult.

The bottom line is that the most certain of things seems to be that Europe is in deep trouble. And the more time that passes with no clarity as to what governments are going to do about the issues there, conditions are creating a flight of money out of the continent. We think that it is still early in that process. More money can leave Europe. And the more that leaves Europe the harder it will be to tell what the consequences are, except for one, which is that Europe is nearing the point of a major financial catastrophe, not in the financial sector, but in the real world where people live their daily lives.

The S & P 500 (SPX) has the look of a tiger ready to pounce, as the Bollinger Bands (green envelopes around prices) are starting to converge toward the 20-day moving average (green dotted line). This is a forecast that a big move is coming as volatility has slowed to the point where prices are being compressed. Price compression is the prelude to price expansion. In physical terms it's a sign that potential energy is rising and that at some point it will be unleashed as kinetic energy, the energy of motion. So far, the S & P 500 has found grudging support at the 200-day moving average. That's bullish, and may be a sign that the next move is to the up side. But it is not a certainty. In order to play this right, we need to see a bit more activity and direction.

Chart Courtesy of StockCharts.com

The small stocks in the Russell 2000 Index (RUT) are in the same kind of technical pattern, with the Bollinger Bands shrinking around prices. Small stocks have taken a bigger beating than large stocks, though, which means that they could lag any rally, and also fall harder if there is a rally and it fails.

Chart Courtesy of StockCharts.com

The Nasdaq Advance Decline line (NAAD) is flattening out. We would like to see this line turn up as it would signal that more stocks are rising than falling. When more stocks rise than fall, it means that investors have a greater chance of picking winners.

Chart Courtesy of StockCharts.com

The action in the Nasdaq Hi-Lo line (NAHL) remains negative. Momentum to the up side has clearly been arrested. The flip side of this analysis is that this tends to be a lagging indicator. Still, the market moves best when the advance decline line and the hi-lo line move in tandem.

Chart Courtesy of StockCharts.com

Conclusion

The stock market is poised for a big move. The direction is unknown although the odds may favor a rally attempt, given the oversold condition of the market.

There are still three major variables to consider, Europe, the U.S. election, and the global economy. Europe seems to be the closest to some kind of definitive point, although that is not entirely clear. The election, in our opinion would be the next most important variable as the action in the economy could well follow.

Investors should be extremely vigilant in this market and not make any huge bets ahead of developments. Cash, caution, and a shopping list are the three key ingredients for success over the next few weeks to months.

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