In my 20 years of trading markets, I can remember very few times when the signals being emitted by different asset classes in global markets were so divergent.
Bond Markets Reflecting Existential Risk
On the one hand, European bond markets are reflecting a level of risk perception with regard to the euro project which is near existential in nature. As I write this, the situation is as follows:
- Italy’s benchmark 10-year yield is at 6.94%, a level which all agree is unsustainable.
- 10-year yields are at 8.21% for Ireland and 11.44% for Portugal. These are yields that are discounting a significantly high probability of default.
- Spanish 10-year yields are at 5.85%. This is significantly better than the Italian yield, but on the verge of unsustainability.
- French 10-year spreads to Bunds are at 166 bps. This is a level of spreads that Italy and Spain were at not long ago and sends a clear signal that French sovereign debt is no longer in the same asset class as Bunds.
Thus, the global bond markets are signaling threats to Europe that are of generational significance.
Other Markets Reflecting Fear and Pessimism
Sovereign bond markets are not alone. Various other markets are exhibiting major stress and pessimism about global growth prospects.
- Interbank markets, reflected in various spreads and indicators, are experiencing substantial stress.
- Various commercial and investment bank shares in the U.S. look to be in the process of testing the catastrophic 2008 lows.
- Chinese equities are near multi-year lows.
- Industrial metals and basic material stocks are mired in major downtrends.
Markets That Are Whistling Past The Graveyard
By contrast, consider some other large and very liquid markets that seem to be reflecting rather sanguine views regarding the ultimate outcome in Europe:
- Global currency markets are pricing the USD/euro at $1.36 – smack dab in the middle of a multi-year trading range, as if things were “business as usual.”
- The S&P 500 (^GSPC) is much nearer the top than the bottom of its trading range for the past two years. The Nasdaq (^IXIC) is pressing up against the top of its range over the same period.
- Crude oil prices at roughly $97 for WTI and $113 are looking positively bubbly.
Déjà Vu?
The last time I can remember such a severe divergence was mid 2008. At that time, debt and interest rate markets were clearly signaling a possible collapse of the U.S. financial system. At the same time, crude oil traders were obliviously driving black gold prices to new highs. Furthermore, equities as a whole were behaving as if everything were “business as usual,” with the S&P ex-financials near all-time highs.
I have had prior experiences with such behavior in my career. For example, in the 1990s, emerging equity markets were notoriously slow in reacting to factors that had been reflected much earlier in sovereign debt markets. Equity and currency crises almost inevitably followed.
Conclusion
In 95% of situations in which I have experienced these sorts of divergences in my career, a collapse of equity markets follows within a few months.
However, just because something has happened in the past does not constitute a persuasive argument in and of itself for predicting its occurrence in the future.
The significance of the divergences pointed to above is that it forces the analyst to come to try to reconcile apparently differing interpretations of reality. If the apparent differences cannot be reconciled, then the market is being priced incorrectly.
Thus, let me be clear: I do not see the aforementioned divergences as a “sell signal” for equities (SPY, DIA, QQQ) per se. I see them as a warning signal that there is a potential mispricing of assets going on in global markets.
In this specific case, for reasons that I have outlined extensively, I believe that U.S. equities, oil and the currency markets are not adequately pricing in the existential threats that are faced by Europe and the entire global economy. Within the next few weeks and months, I believe that those risks will become more fully priced in as the futility of current European policies become more clearly manifest.
In 2008, it was not before several major financial institutions had effectively become insolvent and the entire banking system was on the verge of collapse that equity and commodities markets finally began to reflect the existential risks that were posed. This experience may be repeated in 2011.
Furthermore, it was not until equity markets crashed that policymakers finally took the sort of drastic measures that were needed to avert a collapse of the financial system and the economy. Prior to that, the dominant view was that governments should avoid incurring the costs of a major intervention and allow the markets to “sort themselves out.” This is essentially the script being followed in Europe at the present time.
In the absence of aggressive preemptive intervention by the ECB, the sort of financial crisis that Europe will experience is likely be of a similar magnitude as that experienced by the U.S. in 2008. If anything, Europe’s structural economic problems are magnitudes greater than those faced by the U.S. in 2008.
In this environment, I can see no persuasive reason to purchase equities at this time. Even for attractive stocks such as Microsoft (MSFT), Apple (AAPL) and Pepsi (PEP), any conceivable upside within a one-year time-frame is dwarfed by the potential downside. Under such circumstances, I believe that even very long-term investors would be best served by waiting out the current period of extremely high risk that threatens their capital.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I remain long puts initiated last Friday on various cyclically sensitive equity indices.
