Global Stock Markets In Serious Denial

Includes: DOG, GLL, HDGE
by: Wall Street Sector Selector

by John Nyaradi

Last week, many observers of global stock markets were surprised to see global stock markets and European investors react with a wave of bullishness after Eurostat reported that the eurozone was stuck in recession for a sixth consecutive quarter, because its GDP contracted by 0.2 percent during the first quarter of 2013, despite expectations for a less-significant drop to negative 0.1 percent.

Belief that the report would motivate the European Central Bank to step-up its efforts toward stimulating the European economy sent investors on a buying spree. The first-quarter GDP for the 27-nation European Union contracted by 0.1 percent, which – after fourth quarter 2012 GDP contracted by 0.5 percent – brought the EU into recession with the eurozone. European investors were apparently mindful of the often-repeated reassurances from Super Mario Draghi that the ECB remains "ready to act again" if eurozone economic conditions deteriorate beyond their currently-dismal state.

Eurostat's GDP report indicated that Germany barely dodged economic recession as its first quarter GDP squeaked into positive territory by 0.1 percent, despite expectations that the German GDP reading would indicate expansion by 0.3 percent.

Because fourth quarter GDP for the eurozone's strongest economy was revised downward from negative 0.6 percent to negative 0.7 percent, we might find out in three months that Germany really has been in recession. Despite the economic advance, a May 8 report from Markit Economics suggested that although Germany's economy may have expanded during the first quarter, the second quarter has been signaling more contraction (NYSEARCA:EWG).

Things look much the same in the United States, as last week's worse-than-expected drop in April industrial production was enthusiastically received by stock markets investors, who saw the bad news as justification for the Fed to reverse any earlier plans to taper back its quantitative easing program.

The Federal Reserve's report of a 0.5 percent decline in industrial production during April portrayed a situation worse than that seen by economists, who anticipated a less-significant decline by 0.2 percent. Industrial production took its most significant drop in eight months. Beyond that, manufacturing output dropped 0.4 percent in April after a decline of 0.3 percent in March. The March and April, back-to-back declines marked the first time that manufacturing output fell for two consecutive months since 2009.

Despite economists' expectations that the New York Federal Reserve's Empire State Manufacturing Survey would increase to 3.75 in May from 3.05 in April, the report indicated that the general business conditions index fell more than four points to negative 1.4, further adding to the seemingly divergence between bad news and stock markets euphoria.

If recent grim economic reports had any impact on global stock markets, the only logical conclusion one could reach was that investors saw the bad news as a victory for the cause of eternal quantitative easing and defeat of any plans to "taper back" QE. The Dow Jones Industrial Average (NYSEARCA:DIA) continues setting records on a near daily basis as bad news is considered good and good news is considered great.

The grim economic news continued all week and was accompanied by the same lack of investors' concern for economic reality. The Dow Jones Industrial Average managed to keep climbing in spite of last week's disturbing jump in weekly initial unemployment claims to 360,000, the report on April housing starts and the Philadelphia Federal Reserve's Business Outlook Survey for May, which sank from 1.3 in April to negative 5.2.

China's economic slowdown has been documented by the HSBC China Services Business Activity Index, which dropped to 51.1 in April from 54.3 in March, for the weakest expansion of service sector activity since August 2011. The April HSBC China Composite PMI (which covers both manufacturing and services) declined to 51.1 from 53.5 in March, indicating the weakest rate of expansion since last October. The results were consistent with the government's official manufacturing PMI result for April, which declined to 50.6 from the March reading of 50.9. Worse yet, the HSBC Hong Kong PMI declined to a contractionary 49.9 in April from 50.5 in March.

The June 18 meeting of the Federal Reserve's Federal Open Markets Committee (FOMC) could bring an interesting battle. Last week, Philadelphia Federal Reserve president Charles Plosser remarked that he would advocate a plan to scale back the quantitative easing program. Up until that time, Kansas City Federal Reserve President Esther George had been the only current FOMC member to enthusiastically speak out against QE. Now that the Richmond Fed's Jeffrey Lacker has finished his term as a sitting FOMC member, Esther George has taken up the crusade against QE. On May 9, Dallas Federal Reserve President Richard Fisher pointed out that the lack of job creation is a result of poor fiscal policy rather than monetary policy. Fisher explained that monetary policy had accomplished all it could in stimulating the economy and that ongoing bond buying by the Fed amounts to "overkill".

Richard Fisher's statement was followed by Jon Hilsenrath's May 10 Wall Street Journal report (after the markets closed on that Friday afternoon) concerning a new strategy by the Federal Reserve to taper back its quantitative easing program. The disclosure was carefully timed to give investors an opportunity to process the information and get used to the idea of life without quantitative easing before the next opening bell of the stock market. Nevertheless,recent bullish trading activity demonstrates that investors are not only in denial about the lackluster economic recovery – they also have an alternative "plan B" denial mode to the effect that even if the economy is as bad as reports indicate, that situation would deter the Fed from taking away the punchbowl.

This Wednesday's release of the most recent FOMC meeting minutes, coupled with Fed Chairman Bernanke's trek to Capitol Hill could provide stock market moving insights into the Fed's future plans regarding its quantitative easing programs.

Meanwhile, for those global stock market investors who remain concerned that economic conditions could take their toll on stock prices, the following ETFs present opportunities to make profits as equities and the formerly-invulnerable "safe haven" of gold head south:

Ranger Equity Bear ETF (NYSEARCA:HDGE) – This ETF is designed to obtain capital appreciation through short sales of domestically-traded equity securities. The strategy for achieving its investment objective involves short selling a portfolio of liquid mid-cap and large-cap U.S. exchange-traded equity securities, ETFs, ETNs and other ETPs.

ProShares Short Dow30 ETF (NYSEARCA:DOG) – This ETF is designed to obtain results which represent the inverse (-1x) of the daily performance of the Dow Jones Industrial Average. The fund invests in derivatives which ProShares Advisors believes should have similar daily return characteristics as the inverse of the daily return of the Dow Jones Industrial Average.

ProShares UltraShort Gold ETF (NYSEARCA:GLL) – This ETF is designed to provide daily investment results (before fees and expenses) that correspond to twice (200%) the inverse (opposite) of the daily performance of gold bullion as measured by the U.S. Dollar p.m. fixing price for delivery in London.

Bottom line: Like an addict in search of his next fix, global stock markets are in denial over the possibility that the punchbowl of easy money might finally be taken away after all these years that have led to a serious form of financial addiction. Although the Fed won't go "cold turkey," the addict might still find himself in serious withdrawal should even a small reduction in easy money become apparent.

Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.