It's The Liquidity, Stupid

Includes: ERO, EU, SPY
by: The Other Street

Ok, it’s now all over the news. But you heard it here first, to quote last week’s article:

Tuesday’s action suggests the worst may be priced in. [...] So I'll stick with white, target 1270.

By white, I was referring to another article, suggesting a White Swan, not a Black one, was in the cards:

Unless, and this would be the White Swan, we call it a status quo.[...] Let’s do nothing, no tax increases, no spending cuts, short term. [...] In Europe, the ECB should continue to monetize the deficits.

Well, certainly in the US, we are not talking about fiscal restraint, short term. Rather, we are talking further Keynesian stimulus. And yes, Europe is embarking on a new round of real monetizing. The replacement of Jurgen Stark by Joerg Asmussen is not for "personal reasons". It allows Germany to take take care of its brethen the German way, and the ECB to take care of the rest of Europe. "Tricheur" Trichet is not about to leave under the infamy of a European - read French - meltdown, and "Super Mario" Braghi won't let Italy fail - Roberto Calvi accidentally jumped off a bridge with a noose around his neck for less than that.

Lastly, I pointed out the emerging decorrelation between the S&P and the Eurodollar. While it has been back on for the past couple of days, I continue to believe we have entered a secular trend, where the S&P can move up while the Euro goes down – see chart below:

click to enlarge

What would be the drivers for this change? First, relative financial stability. Since 2007, and except for the early 2009 when the dollar strengthened against the Euro in response to the crash, the Euro has by and large been strong against the dollar – this is an old chart from my book, but it tells the story:

Why would this trend reverse? Simply put, we opened the kimono in 2007 and Europe is still wearing its underwear. Time to wash’em. European banks have been able to fake their “strength”, game over. WE get to shoot again. Indeed, I have surmised that in theory, should we break the Euro into its components, only the Deutsche Mark would revalue. The sum of the parts, in my mind, is way lower than the whole. If I have to venture a number, I have used 1.25 before, and I’ll stick to that for the time being since it was the 2009 low.

Which brings me to the second potential driver, relative political stability. I know, these two differentials are not taught in Forex 101, but having been around for a while, I have observed they work. What’s the landscape? For a while, Europe seemed to have stable leaders. Merkel had been elected in 2005, replacing US foe Schroeder; Sarkozy in 2007, replacing US foes Chirac/Villepin; Britain was our friend under Blair and his successors.

In the US, we went from stable Bush, whether he was liked or not, to unknown Obama/Biden/Pelosi/Reid/Frank/Dodd.

Well, this too may change. In Europe, certainly the “stability” of the odd couple “Merkozy” is being challenged. Not to mention the whole of Europe. If you think we are in trouble, you’ve not been watching TV, or reading my articles… Now, for sure, we also are in trouble. Relatively speaking, this is called an unstable equilibrium. The question, which way will it stabilize, meaning are we going to go back to a stable balance, or will one of the two strengthen? My bet is that the pendulum swings back to the US. Already, the Senate 2012 race shows it is for the Republicans to lose. To quote Larry Sabato and his Cristal Ball, my favorite scolar on the subject:

Remember, there are 23 Democratic-held Senate seats up for grabs this year, versus only 10 Republican-held seats. Realistically, only two of those 10 Republicans seats will be competitive next year: Nevada, a purple state where appointed Republican Sen. Dean Heller faces a tough challenge from Democratic Rep. Shelley Berkley; and Massachusetts, a deep Blue state where Republican Sen. Scott Brown will try to hold on against an as-yet unknown Democratic challenger. Both Republicans are vulnerable, but favored. Meanwhile, Republicans have plenty of chances to gain the four seats they need to guarantee them control of the Senate next year.

With the House likely to remain Republican – Democrats need 25 seats, which is historically improbable, - Congress is bound to become Republican. If Obama is reeelected, a slim chance in my opinion given the meaning of the recent Turner victory in New York’s Queen and Bronx districts, we’ll have a stable lame duck four years. If a Republican is elected, and I do not know who it would be at this juncture, you’ve got the picture. In both cases, a more stable environment than today.

The same is unlikely in Europe. The current disputes highlights the nationalistic divergences of each country, and austerity programs, compounded by unbridled immigration, will bring social unrest. Already, the extreme right is making progress, certainly in France. I don’t expect the system to break down, but I have seen it in disarray before. Rest my case.

The last driver I’ll mention is relative economic growth. This one is tougher to call as it seems both the US and Europe are in the middle of a slowdown. We used to say “when the US sneezes, Europe catches a cold”. Now that we are done watching the European drama, it’s time to go back to proven truisms. So, by all counts, mine that is, the current strength in the Dollar versus the Euro should be the start of a new trend. When these reversals really occur, they last for years, see the graph above.

What about the markets? What does Europe have to do with them? Well, It’s the liquidity, stupid. For stocks, if it was fundamentals, the current earning yield of 7.5% versus the 2% 10-year Treasury would imply a massive drop in earnings, akin to 2009.

While I do expect earnings revision, in particular for companies exposed to Europe, it’s not going to be massive. Say the S&P, instead of earning $100 in 2012, earns $80, a big cut already. The earnings yield moves to 6.6%. If the environment stabilizes, we are soon going to wake up to the fact that we only reached this level because of irrational Liquidity Crisis fears, a la Lehman. This is mostly evident for companies with a leveraged balance sheet. They are trading as if they will not be able to refinance, period.

To be clear, my target of 1270, which I have maintained for a couple of weeks now, is conservative. I just want to observe the reaction of stocks to Q3 earnings. I have long maintained that more than the news, it is the reaction that counts. The consensus seems to be that stocks will react negatively. If I am correct in my liquidity fear assessment, we first have to correct this by a revaluation to the upside. At the current levels, I’ll posit that the combination of such revaluation, even coupled with likely disappointments, is unlikely to translate into lower stock prices.

Notice, by the way, that the dreaded technical bearish flag did not break down, despite an attempt to do so. My next resistance seems to be 1250, a confluence of trendline and Fibonacci retracement. Let’s see if we get there, and how. In the meantime, we’ll have a better read on Q3, whether it is Q3E, as in earnings, or QE3, as in the Fed, or the ECB for that matter. For the record, this was written on September 15 at 14:00, the S&P 500 was at 1203 and the EuroDollar December Futures were at 1.3874.