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Over the past weeks, I wrote about how, from a technical viewpoint, the major risk barometers like the S&P 500 charts looked resilient, despite miserable fundamentals. Last week, I noticed signs of cracks in that resilience, & wondered how long that could continue. Now we know.

PRIOR WEEK: The Reality of Bad Fundamentals Hits the Charts

Last week saw the biggest declines in risk assets since October 2008, when the current Great Financial Crisis really got going, and ended in the March 2009 market lows. For example, the DJIA lost 5.75 %, and the S&P 500 -7.19%. Most major global indexes went from being comfortably positive to firmly negative for 2011.

Oddly, at first glance, none of basic the fundamentals being blamed for the collapse are new. You’ve probably heard about these ad nauseum this week, so we’ll keep it brief.

  • The EU sovereign debt and banking crisis is looking mostly (ok, somewhat worse) like it’s where it was last year, another round of bailouts linked to austerity measures to defer an eventual Greek default, supported by yet another round of farcical bank stress tests. Ireland and Portugal needing more help is also old news. Spiking GIIPS bond yields are worrisome, but nothing new. Ok, one new thing, the Greek part of Cyprus is now ready to join the bailout club, so now we can call them the “GIIPS-Cs”. The only really big change in the EU’s approach, haircuts for GIIPS-Cs bond holders (a game changer for sure because it raised bondholder risk and thus must raise yields to compensate for that added risk), as we’ve noted in the past weeks’ posts) is already at least 2 weeks old, and it was clear to most intelligent observers that from both a financial and political perspective, some kind of restructure/partial default was due at some point. The EU couldn’t afford to offer a guarantee on GIIPS-C debt forever, and voters in both funding and debtor countries were losing patience with the pain of paying for bailouts or austerity programs imposed from them
  • Slowing growth in virtually every major economy has been a given for months at a minimum. So the worst US manufacturing ISM reading shouldn’t have been too shocking.
  • The US debt ceiling fight was long assumed to be something that would be resolved, or at least deferred; and after some drama, it was, at least for the coming months.

So it’s not enough to simply blame the combination of the above. We need some explanation for the timing – what happened this past week? More importantly, what does it tell us about next week and beyond?

So, what were the fundamental changes behind the technical collapse we saw on the charts? Here are the main market drivers of the past week’s panic

The short version: the assumptions of government support for private investors are no longer valid on either side of the Atlantic. That means risk assets are far, well, riskier, than before, and markets are justifiably scared.

The US

The first suspect is the one truly new fundamental factor, the end of the first round of the US debt ceiling fight and the new reality it revealed – that the assumed “Washington put” (some kind of serious spending to prop up the economy when things get really bad) can no longer be taken for granted. In the long run that ‘s a good thing, the US does need to cut spending and get its deficit down, and there will be no “good” time to do that in the coming years of slowing growth. Spending cuts will hurt growth, period. However, markets didn’t believe the time had come when Washington might really say no. Surprise, it probably has. The debt fight showed just how much political opposition there is for any new stimulus spending that isn’t matched with a countervailing cut somewhere else in the budget. See here for more on this.

This is a huge change. Remember last summer how Appaloosa hedge fund founder David Tepper correctly called a new rally once QE 2 was announced, and how often QE2 was cited by Morgan Stanley and others as the fuel behind the most of the rally that began late last summer and which really took off once QE2 became a reality? Tepper reportedly said in June that he felt Bernanke might kick in QE 3 if the stock market really tanked, but that was before the latest debt ceiling fight revealed the likely political opposition to more stimulus. We leave aside the considerable evidence that QE 2 did little but sustain asset prices, given that added liquidity is not going to help when the private sector and households are trying to cut debt and spending. Some form of QE 3 might yet appear, perhaps once again at the Jackson hold gathering in late August (where QE2 was officially born last year), but the odds are lower.

The EU: Imposition of Haircuts Backfires, Accelerates Contagion

Here too, assumptions that the EU would ultimately guarantee GIIPS-C bond debt were proven wrong less than 2 weeks ago, and the effects really hit this week for Spain and Italy, either of which alone is considered too big to rescue.

Just about 2 weeks ago, the EU’s latest Greek rescue plan revealed that the private sector was going to be hit with 20% haircuts on its Greek bonds. Leave aside the likelihood that the losses will probably be much higher (they’re instantly worth less now that haircuts are in the picture, and who said Greece could pay back 80% of their debts?).

As we’ve warned for weeks, because GIIPS-C bonds now come with unknown risk of loss, their yields are rising as the very private sector needed to buy this debt now needs much higher yields to compensate for the unknown risk. While yields on these bonds had been rising throughout the prior week’s as the second annual Greek bailout came together, this really started backfiring after the latest EU rescue plan of July 25th. Trouble for the too big to bail nations of Spain and Italy started almost immediately.

By Friday July 29th, Moody’s had put Spanish government bonds on review for downgrade and had downgraded or placed on review a batch of major Spanish banks. Meanwhile Italian stocks, which had just hit near term highs, went into freefall, with the FTSE Italia MIB falling from 19000 on July 25th to 16000 as of August 5th, a nearly 16% drop. The carnage was far worse with Italian bank shares due to their heavy exposure to Italian and other GIIPS-C bonds. Trading in certain Italian bank shares was periodically suspended. This sudden severe deterioration in far too big to bail, Italy in turn, has been scaring markets worldwide and been a major drag on US markets this past week.

The ECB and EU are well aware of the risks of imposing haircuts on bondholders. That the EU is imposing these anyway suggests that the funding nations, particularly Germany, are no longer willing to bear the cost of bailouts alone, even if that risks the very existence of the EZ and Euro, at least as we know it.

With both Spanish and Italian 10 year bond yields nearing the 6-7% range that for the other GIIPS meant they needed a bailout because they could no longer afford to access credit markets, that time may be approaching sooner than previously believed.

Global Economic Data

The overall results last week for the data that mattered were mostly bad, with the big exception of Friday’s mildly better than expected US jobs reports, which helped US indexes close basically flat and kept weekly losses at their already worst since 2008 levels

The Technical Picture: At the Brink of the Abyss

To appreciate the importance of these changes last week, let’s look at just how much technical damage was done and the ramifications of that damage. Understand that until this week, risk assets were still holding up quite well given the above dire fundamentals, and the ongoing pullback since mid-May looked like nothing more than a normal ~10-15% pullback. Heck, we’re still only 12% down from the May high, hardly a dramatic drop quite yet.

Yet sudden sharp trend reversals like that of the past week are like deep wounds, they take longer to heal, barring some very potent new treatment. Once again, we refer to the S&P 500 chart as an overall market barometer of risk assets.

First, let’s look at the monthly chart for a big picture view. [Click all images to enlarge]

ScreenHunter 02 Aug 07 04 11  WEEKLY MARKET MOVERS 1: WEEKLY MARKET MOVERS 1: THE REAL REASON MARKETS GOT CRUSHED

S&P 500 MONTHLY CHART COURTESY ANYOPTION.COM 02aug 07 0411

There are many points I could make about this chart, but here are the really important ones.

Note the red arrows on the left and in the middle of the chart. They highlight how in both the dotcom bust and the Great Financial Crisis Part 1, what had been a normal pullback became a market plunge when:

  • An unusually long red (losing) monthly candle closed below both its 20 month (yellow) and 50 month (red) EMA.
  • The plunge was both confirmed and magnified once the we got:
    • A monthly candle close beneath the 200 month (pink) EMA.
    • The 10 month (blue) EMA crossing under the 20 month (yellow) EMA.

Now look at the third red arrow on the far right. It highlights August thus far. Admittedly, it’s still early in the month, but just be aware of how close we are to repeating ALL of the above conditions if August doesn’t close any higher. Ominously, because we’ve been in an overall downtrend since late 2007, we may soon not only breach the 50 month (red) EMA, but the 200 month (pink) EMA, which the past indicates will open the door to a plunge below 800, a re-visit of March 2009 lows.

Looking at the weekly chart below, here are a few other ominous signs worth noting.

ScreenHunter 03 Aug 07 04 31  WEEKLY MARKET MOVERS 1: WEEKLY MARKET MOVERS 1: THE REAL REASON MARKETS GOT CRUSHED

S&P 500 WEEKLY CHART COURTESY ANYOPTION.COM 03aug 07 0431

When we get a weekly close within or beneath the area bounded by the 2 lower Bollinger bands (red and yellow) that demarcate the Double Bollinger Band Sell Zone a breach of the 200 week EMA, there is more downside ahead (also seen on the weekly chart the week of June 27 2008 not shown here. That one marked the start of a deep pullback, the one in May 2010 (red arrow in the middle of the chart), only a minor pullback that was most likely halted by QE2. As noted above, the chances of a similar assist to the market, and to risk assets in general, is now far reduced.

Lessons & Ramifications

All of the above bearish fundamental market drivers are likely to be around for a while longer. Given the factors discussed above -

  • bearish fundamentals now starting to show up in the charts as shown above...
  • the overall risk asset market down trend since November 2007...

The odds of a new, bearish trend within the longer term bear market have grown markedly.

That both the EU and US appear to be hitting an exhaustion of political will for the very bailouts and stimulus that has kept markets aloft since March 2009, the time for deferring the pain of reducing sovereign and clearing bad debt off of bank books, and incurring the feared double dip recession, or worse, may suddenly be far closer than previously believed.

What to Do?

The general moves would include:

  • Lighten up on risk assets, rebalance your portfolio to safe haven assets or those that benefit from declines in risk assets, like monthly binary options on stock indexes or risk currency pairs, inverse ETFs (like SDS for playing a drop in the S&P 500) or stock index plain vanilla put options.
  • If the EU and US avoid new attempts to spend their way back to growth via QE 3 and its EU variants, and risk the value of the USD and EUR, currency hedges like gold will see more upside. This is a real possibility.
  • If not, we could see some deflation that would likely bring a pullback for gold and other currency hedges.
  • Over the longer term, both the EUR and USD remain dubious places to store one’s wealth. Thus in addition to some precious metals, liquid assets and income producing liquid assets should be in currencies of nations with sound finances (like the CAD, AUD, CHF, NOK, and SEK).

Disclosure: No positions.

DisclaimerThe above is for informational purposes only. All trade decisions are solely the responsibility of the reader.

<<click here for part 2<<

Source: Weekly Market Movers: The Real Reason Markets Got Crushed