In my most recent article on market strategy, I discussed several potential upside or downside catalysts for the U.S. stock market (^SPX, ^DJIA, ^IXIC, ^NDX) going forward.
- U.S. monetary policy.
- Super-committee surprise.
- Improving consumer and business sentiment.
- European fiscal and monetary policy.
- Third quarter earnings and guidance.
Of these only No. 4 and No. 5 might come into play next week.
Europe: Greek Bailout Looking Cheap By Comparison
Regarding Europe, statements by the Austrian finance minister and others are hinting that a grudging consensus may be building that it will be cheaper to continue to bail Greece out than to clean up the Europe-wide mess if Greece is allowed to default.
In this regard, a slew of estimates were published this week regarding the sort of Europe-wide bank recapitalization that could be triggered by a Greek default. Estimates vary, but assuming a 50% hair-cut to Greek debt plus recognizing some degree of marked-to-market losses on the debt of other peripheral nations (e.g. Italy and Spain) could require a re-capitalization in the magnitude of $200-$400 billion euros. Presumably, such recapitalization of banks such as Banco Santander (STD), Deutsche Bank (DB) and ING (ING) would require a TARP type program that would very much strain the limits of European institutions – not to mention how unpopular such a measure would be.
In my view, the capitalization estimates cited above underestimate the problem because they only take into account the hit on the sovereign debt. Credit to the private sector is a much larger problem. In particular, the prospect of a mortgage crisis similar to the one experienced in the U.S. is very grave given that the level of overvaluation of residential real estate in Europe is magnitudes greater than it ever was in the U.S. Tradng volumes in credit default swaps on the debt of European banks have been soaring in the past few days - an indicator of increased nervousness regarding the solvency of European banks.
U.S. Corporate Earnings: Hints Of Downside
With regard to U.S. corporate earnings, a key risk is that investors have been extremely spoiled by fabulous corporate earnings in the past two years. Thus, negative surprises could be particularly damaging. In this regard, three things concern me.
- Sluggish demand for low-end semiconductors. Pre-announcements by Texas Instruments (TXN) and other commodity analog chip manufacturers seem to be signaling a global slowdown in product demand.
- Slowing demand for copper and iron ore. Recent comments by Rio Tinto (RIO) regarding slowing global copper demand could be a harbinger of slowing world-wide industrial production. Along the same lines, demand for iron ore produced by companies such as VALE (VALE) on the part of steel producers worldwide such as Arcelor Mittal (MC), and particularly producers from China (General Steel (GSI), China Precision Steel (CPSL), Sutor Technology (SUTR), China Gerui (CHOP), Ossen Innovation (OSN)), also seems to be waning.
- Potential margin compression. Deceleration of productivity growth in the U.S. and the wide gap between PPI and CPI could portend profit margin contraction.
It is my view that in the absence of significant good news from Europe, stocks will tend to trade toward the bottom of their recent ranges established between around 1,100 and 1,230 on the S&P 500. Furthermore, it is my view that the news out of Europe would have to be quite bad for stocks (SPY, DIA, QQQ) to break the lower end of this trading range.
In my view, earnings will ultimately be the deciding factor regarding whether the 1,100 area on the S&P 500 will hold. In this regard, I believe that investors will be extremely sensitive to any corporate news next week that could provide a preview for the upcoming earnings reporting season.
It remains my view that the market will ultimately test the 950-1,020 area on the S&P 500 before the end of the year. As such, even though I consider that stocks such as Apple (AAPL), Microsoft (MSFT), Intel (INTC), AT&T (T), Verizon (VZ), Pepsi (PEP) and Goldman Sachs (GS) represent good value at current levels, I believe that these stocks will ultimately be available for purchase at levels 10% to 20% below current prices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.