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2012 was not a kind year to the German economy. For a majority of the year the German economy was in contraction, fighting headwinds from the European Debt Crisis and a strong Euro. Mr. Market however didn't seem to notice. The iShares MSCI Germany Index Fund ETF (NYSEARCA:EWG) returned 28.51% in 2012, more than double the 13.47% of the S&P 500 (NYSEARCA:SPY). Germany was the second best performing country index behind Mexico (NYSEARCA:EWW) which was up 31.19%.

Auf wiedersehen 2012 and thanks for the memories, but was this performance warranted and is it going to continue in 2013?

The German economy is very much like the US economy

The service sector contributes to around 70% of the German GDP, industry 29% and agriculture about 1%. Most of us think of Germany as a manufacturing powerhouse built around exports similar to China, but in fact the composition of the German economy is more like the US economy where the consumer is king. Let's look at the German Economic Heatmap:

(click to enlarge)

Source: macrochart.com

Clearly a majority of the economic indexes spent the summer and fall in contraction territory. The PMI Manufacturing index fell below 50 in March and didn't stop going down. The Industrial Production was negative in 6 of 12 months. Business Expectations fell for 6 consecutive months in the middle of the year in both the IFO and ZEW surveys.

Source: macrochart.com

The service sector numbers showed surprising strength, however. The Markit/PMI Services index was above 50 in 8 of 12 months and rebounding strongly near the end of the year after the usual summer dip. The retail sales were mixed throughout the year, but closed out with a strong 1.2% November (December number is not in yet). And the IFO Economic Sentiment bounced pretty well off its lows in October.

Source: macrochart.com

As such if you focused more on the bad manufacturing indicators that came out of Germany last year, you would have been really perplexed at the strength of the country's market performance. The positive service numbers, however, do provide some credence to the bull run given the higher importance of the service sector.

But, as it should be clear from the charts above, while the numbers show some seasonal strength they are decidedly weaker than the beginning of 2012:

All indicators with the exception of the ZEW Business Expectations are significantly lower. Once the winter ends and we move to the slower economic activity period of the spring and summer, I am not sure that the current economic uptick will continue. This makes me think that the current rally in the EWG may be a bit overdone.

Money is flowing into Germany

Due to the European Debt Crisis and the instability of banks in Portugal, Spain, Greece and Italy, depositors have been fleeing their countries' banks in favor of the well capitalized and stable banks of Germany and Austria. German deposits are now bigger than the combined deposits of PIGS countries:

Source: Council on Foreign Relations

Some of these deposits are eventually making their way into the German stock market boosting its performance despite questionable fundamentals. This is a trend that will likely continue into 2013 and a trend that will provide support for the DAX.

How to play it

I am bearish on the EWG in the near term (1-3 months) and bullish in the long term (6 months out). Since the DAX is the most liquid stock market outside of the US, whenever there is trouble and uncertainty in the market and institutional investors feel like they should dump international stocks, the DAX tends to be the place bearing the brunt of the panic. In May of 2012, the EWG experienced a 17% drawdown almost double the 8.9% drawdown of the SPY. Given its volatility, the EWG represents an excellent long/short opportunity that will yield market-beating returns for the astute macro investor who times it correctly. Let's look at a recent daily chart of the EWG:

(click to enlarge)

The EWG is clearly in a bullish trend and now trades at the highest levels in a year. It looks like it has just completed a strong 2nd wave up culminating in an island reversal. There were a series of high volume trades being done around the 22 level in September and October which means that 22 is going to be a pretty strong support level going forward. OBV is very positive and the RSI is fairly strong although weakening in the last week.

I would propose the following trade - Short EWG now at 24.50 with a stop at 25.00. If the EWG goes down, cover at 22.00 or around the 200-day moving average and then turn around and go long. That would represent a 10% return on the way down and a 14% return on the way up after the correction if the EWG reaches 25 again by the end of 2013.

Source: EWG: Auf Wiedersehen 2012