Cyclicality vs. Euro Calamity

Right now, the observations for 2012 seem to pit measurable economic recovery data based on ISM numbers, sales growth, and employment versus a debt problem that hasn’t been resolved by the ECB or the EU. We seem to be at an impasse between these two forces as the equity markets have rallied since October, but have failed to press the matter further despite rising economic indicators. It’s fair to say that the market has merely tread water since the October 27^th European Leader Summit. Has Europe capped the economic recovery story since September? The euro is falling, but is it falling for the right or wrong reasons? I’d like to use today’s Market Observation to delve into these issues because despite a very strong week in economic indicators, the U.S. equity market has failed to break above key resistance.

Capping the Recovery

It’s fairly clear that the U.S. economy is strengthening given the rising ISM manufacturing index, falling unemployment, falling jobless claims, housing data, and low interest rates. I’ve been dedicating a good portion of the 15-minute segment on the weekend edition of the Financial Sense Newshour discussing these developments in detail since September. Some analysts may argue the market has recovered from the October low because of these items; however, since the October 27^th European summit, the market is essentially flat at this moment – all while economic numbers continue to “look better”. The question I’m asking myself, despite very bullish outlooks by many of the reports I’m reading is, “has Europe capped the economic recovery story?”

I think that question will continue to pertain to the current market over the short-term as we face the highs from October 27^th, 2011. Over the past two days, the U.S. market has sold off in the morning due to weakness in European markets. Once Europe trading closes, the market gets treated to an afternoon rally based on strong economic data in the U.S.; however, the good news has not been enough to break the October 27^th high. If the market can break above that resistance level (whether from strong economic data, earnings, or a euro pact), the market will essentially publicly announce it has shrugged off rumblings in Europe, though perhaps only over the short to intermediate-term. The debt problems in Europe are structural and will require time for the right balance of austerity to appease creditors and stimulus to turn things around. Recall that bearish sentiment over European issues went away in August of 2010 and credit default swaps on European debt collapsed once the leading economic indicators for the U.S. and Europe began to rise again.

Euro falling for the right reasons

So far, we’ve had two months of improving manufacturing PMIs in Europe. The German DAX and the DJ Euro Stoxx indices are all up 20 to 25% since the October low. In addition, the euro is falling – for the right reasons. Let’s look back in May and June of last year. The Euro / USD began to rollover at key resistance near $1.50. At that time, the traders were focusing on whether the ECB would stop raising rates and thus end its restrictive policy bias. With manufacturing rolling over and debt issues arising again in the periphery, the Euro fell from $1.49 down to $1.38 before being defended one more time by the ECB in July with a rate hike. Then, in August, the ECB announces sovereign bond support and essentially shifts from restrictive monetary policy to accommodative policy as the leading economic indicators were rolling over and equity markets were falling precipitously in fear. Now, we have the euro falling below the January 2011 low with very accommodative moves by the ECB over the past three months. In other words, the euro is falling based on monetary accommodation and not so much on fear. If it was dropping on fear, we’d be seeing European equities falling in tandem, but that’s not what’s happening as the chart below shows.

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Late November was a key pivot in this relationship. What happened at the end of November that caused this inflection point? Central banks made a joint strike on currency swaps providing major liquidity and China lowered its reserve requirements. Central Banks and governments have shown they’re perfectly capable of intervening. If they hadn’t, there was no doubt that equity markets were headed towards the October lows again. Just as restrictive monetary policy and inflation eventually crack the economy, in the same way monetary stimulus and lower inflation stimulate a recovery. A falling euro now on accommodative monetary policy changes means cheaper exports and greater tourist demand. The European manufacturing ISMs are proving that relationship now. The euro is falling for the right reasons. It’s the perfect time to buy a Mercedes or BMW!

I’m not saying the Eurozone debt issues are resolved. I’m saying that stimulus is here and central banks are now a tailwind supporting the markets instead of a headwind to combat inflation. Eventually, that will stimulate the economy and cause credit agencies to pause their downgrades like we saw in 2010. If Europe’s economy recovers, credit default swaps will fall. The euro bears must not forget that there are two variables to the European debt crisis: expenses and revenues. Then it’s up to politicians to perform the austerity measures needed to pair back spending once the economy recovers; unfortunately, that’s not typically what happens.

Uncertain Times

These are still uncertain times. As cliché as that sounds, many of the tailwinds in the 80s and 90s—even the tailwinds from the 2000s with cheap credit and a rising housing market ATM where equity could be withdrawn—are no longer with us. Savers have to cope with a low interest rate environment forcing them into riskier investments to get a real rate of return. The Fed Funds rate isn’t at 9%, it’s at 0. That means the Fed can’t lower interest rates any more than they are to stimulate the economy. Ask anyone about what they think about tax policy over the next few years and you can see the instant fear. That means we don’t have the fiscal ability to stimulate like we did in the 80s and 90s. Governments are shifting towards austerity as we deal with unfunded pension liabilities and the excesses of large government. It almost feels like the only tailwind we have is monetary inflation through rising bank reserves from the Fed. The other two tailwinds are a falling savings rate and rising credit.

Previously, deflationists had correctly nailed that money velocity was just as important as monetary stimulus through quantitative easing. Paul Kasriel of Northern Trust has shown in his research that bank credit is once again a tailwind.

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Source: 2012 – As the Fundamentals Improve Stateside, They Deteriorate Abroad by Paul Kasriel, Chief Economist of Northern Trust

Technically Speaking

Technically, I believe January is going to set the tone for the first half of the year more so than I’ve seen in the past ten years. We’re at technical resistance now, just below the October 2011 highs. The setup if we breakout above 1285 is a very bullish one, an inverse head & shoulder pattern with a higher low mid-December. I didn’t expect us to break that resistance before the earnings season because of how many companies have warned in December despite good macro-economic data. I think a lot of investors are waiting to see just how much of an effect Thailand flooding had on technology companies. We had some encouraging results from Seagate Technologies earlier in the week on hard drives, but the proof will be in the pudding this earnings season, and that’s right around the corner next week with Alcoa on Monday. The last few earnings seasons have shown a majority of companies beating estimates, however, a record number have also made warnings in their forward outlooks, making the picture a little more uncertain.

Looking at the S&P 500, some could argue the market has already broken out of a head & shoulder pattern with a declining neckline. It’s a valid pattern, but I find volume lacking on the breakout. Here’s what the chart looks like:

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I’ve found a more horizontal approach to necklines more to my liking. If that’s the case, let’s use the October highs as resistance and our neckline:

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The target on this pattern is 1411. I found that interesting considering some of the price targets I’ve read for the year.

So technically speaking, January sets up the direction for the market in a very big way. The earnings season is right around the corner. Like I've said on the radio show and my previous articles, it wouldn’t surprise me to see a rally in the next couple of weeks leading up to earning season. Despite strong macro-economic announcements to finish the quarter, we’ve had a record amount of companies warn in the past two months. We know that ending the 3^rd quarter and beginning the 4^th quarter was a difficult time for companies and consumers with fears over Europe and Congress’ ability to work out the debt limit, but it appears those fears are easing in U.S. and European equities and the leading economic indicators have begun to rise again. Even in China, despite a major technical breakdown below 2300 for the Shanghai index, stronger ISM numbers and the prospect of another cut in the bank reserve requirement from the PBOC seem to be stabilizing prices there since December 20^th. The MACD on the Shanghai index is no longer in decline, but has triggered a buy signal. Despite the economic strength this week in the U.S., Europe concerns continue to weigh on equities. We saw a selloff in the morning every day since Tuesday, only to rally in the afternoon as soon as Europe closed trading. A breakout above 1285 would essentially state the market is moving on from these issues, at least for now.

Catalysts Ahead

At the impasse we find ourselves in below 1285 on the S&P 500, there are some events in our near future to focus on. First and foremost is Alcoa’s earnings announcement on Monday. As I write, Alcoa is up 5.7% this week. Alcoa is a bellwether on basic materials and industry. So investors will be watching for signs of economic recovery at the micro level on Monday. We’ll also hear from Chevron and JPMorgan as some of the other bellwethers next week.

The ECB meets on the 12^th. If European banks won’t lend to each other and decide to stick reinvesting those funds back into the ECB, they may try to tweak something differently; however, at 0.25%, the banks won’t be able to keep funds with the ECB deposit fund in perpetuity. Consensus believes we’ll have a “wait and see” announcement due to all of the changes over the past two meetings.

On the Eurozone front, Merkel and Sarkozy will meet early in the week and then again on Wednesday with Italy’s Mario Monti as they reiterate shared goals. In addition to meetings, we’ll start to get debt auctions from Spain and Italy, considered periphery countries now.

This was probably the most exciting week in economics for the month, but next week we’ll get import and export data from China, U.S., and Europe.

We’ll also get some Holiday sales updates from Gamestop, Tiffany & Co, and Williams-Sonoma.

In Summary

Equity markets have rallied on joint central bank stimulus, economic strength, and administration change in Italy, Spain, and Greece. The euro continues to decline, but European bellwether equities are flat. Economic indicators in Europe have shown some improvement, but trade data next week should really help us understand whether the euro is falling for the right reasons towards stimulating exports. We’ve had a record number of companies warn leading into the earnings season, and that may have tempered the December rally. It’s time to get down in the trenches next week and hear from the companies themselves to understand how the economy or respective industry group is fairing. With only 50% of the S&P 500 trading above the 200-day moving average as of today, the market tape is split and stock picking carries a premium. It’s going to be an interesting and important January.