The stock market is taking another run at heavy resistance.
After bleeding lower through the Thanksgiving holiday, stocks have come back to life in a resounding way. It all began last Monday when stocks suddenly exploded higher on what we eventually learned last Wednesday was a globally coordinated monetary policy response to the European sovereign debt crisis. This swift rally quickly returned stocks to a critical level, which is the 200-day moving average (red line on the chart below) on the S&P 500 Index. However, stocks have their work cut out for them from here, and the European sovereign debt crisis remains at the heart of the challenge.
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The 200-day moving average has proven a major challenge for stocks over the last several months. After cascading lower in late July, it took stocks nearly three months to return to this resistance level. And in its two recent encounters with the 200-day moving average in late October and early November, stocks failed and moved decisively lower off of this mark.
Hopes are high that stocks can finally break out above its 200-day moving average this time around. Stocks have already made a run at this resistance level on three separate instances over the last three trading days. In each occurrence, stocks were pushed back lower.
But the catalyst that many investors are hoping will push stocks over the top is due to arrive in the coming days. This, of course, is the pair of meetings for European policy makers at the end of the week. On Thursday, the European Central Bank (ECB) is scheduled to meet and many are expecting that they will cut interest rates and potentially engage in the asset purchases that the market has been long anticipating to finally address the sovereign debt crisis across the region. Also on Thursday and into Friday, European leaders are set to meet in Brussels for a summit from which many are expecting bold policy actions to also finally begin resolving the crisis.
This is the time we’ll finally see substantative results and actions from European policy makers, right? After all, don’t they simply have to take decisive action this time around? Despite the market optimism leading up to these meetings, I have some genuine doubts that we’ll see any meaningful solutions coming out of these meetings. Instead, the stock market may be set up for disappointment once again.
A variety of practical questions are worth consideration when looking ahead to these meetings in Europe. And many of the probable answers suggest the outcome may tilt toward the negative side for stocks.
First, why should we really expect a solution this time around? European leaders have been dithering with this crisis for over a year and a half now. And we have had numerous meetings along the way that were supposed to be that key meeting where European policy makers were finally going to take the action necessary to resolve their debt crisis. In each and every past instance, European leaders have come up short and small with proposals that have lacked in both urgency and detail.
We have seen this story so many times already, so why exactly should we expect anything different from these latest meetings? How many more times will investment markets allow themselves to be fooled by running up sharply into these meetings only to be disappointed in the end? A healthier market would be one that exhibited the discipline to act on the introduction of true policy solutions instead of recklessly rallying into each Eurozone policy meeting only to have hopes dashed each and every time when these solutions never come.
Second, where exactly is the money coming from that is propelling stocks on these hope driven rallies? It certainly hasn’t been the historically much maligned retail investor, as stock mutual funds have seen net outflows of $21 billion for 2011 year to date according to Lipper. And it’s not as though this money is moving from mutual funds to exchange traded funds, as the net outflow from open-ended mutual funds versus ETFs has also been roughly $21 billion so far this year. In other words, retail investors have been stepping out of the way of the stock market throughout much the year. Clearly, this is an institutionally driven market. But if the crisis across Europe begins to infect these same institutions and force mass liquidations, the downside could become particularly sharp as few buyers will remain to catch the falling knives.
Returning the focus to Europe, what exactly is the incentive for economies struggling with debt across the region to carry out reforms? The biggest dilemma facing EU leaders since the beginning of the crisis has been the inability to actually carry out the discipline threatened on the bad actors. When you get down to it, why exactly should Italy or Greece actually deliver on the austerity measures that they repeatedly promise along the way? Instead, it makes more sense for them to simply do and say just enough to get the needed bailout funds and then return to status quo. After all, European leaders have their hands tied to a large extent, for if they actually carry out on the threats to withhold bailout funds or expel a country from the monetary union, they would essentially be tearing themselves down and the euro currency along with it in the process. In certain respects, it is the equivalent of the inmates running the asylum.
How about the downgrade threat by S&P? Won’t this induce leaders across the region to act? The answer – probably not. U.S. policy makers have faced the same downgrade threats by S&P throughout much of 2011, but it’s not as though it changed behavior to any meaningful extent. So why then should we expect European policy makers to behave any differently? After all, the market will determine what interest rate it is willing to pay on debt at the end of the day.
One has to look no further than the yields on AA rated U.S. Treasury debt versus some of its AAA counterparts across Europe to see that investors will look past the rating agencies to make their own decisions. On a separate note, it is highly questionable that a rating agency like S&P feels compelled to use the influence that accompanies its position in global credit markets to try and influence policy debate in any way. This is a highly debatable overstep, as it only injects yet another layer of uncertainty into markets that already have enough volatility to navigate.
In certain respects, it seems in many ways that European leaders are missing the urgency of the situation anyway. The recent announcement coming out of the latest meeting between German Chancellor Merkel and French President Sarkozy was just another example of this point. Earlier this week, they came out with the joint agreement that changes to the EU treaty should be made to penalize countries for future fiscal budget violations. Really? This is what they were spending their time talking about? This is great idea for down the road, but now is not the best time to be focused on future problems.
This announcement was the equivalent of saying your planning on installing a sprinkler system in your house as it’s already in the process of burning to the ground. And if this announcement was meant to inspire confidence that more concrete solutions were coming later in the week, I am more than underwhelmed.
But what about the pressure coming from abroad? Many continue to call for European leaders, particularly those in Germany, to take decisive action. This includes U.S. Treasury Secretary Timothy Geithner, who travelled to Europe this week to meet with EU policy leaders ahead of their summit later this week. But when standing back to think about this idea, who is the U.S. really to be telling European leaders what to do? After all, we did a good job of making a hash of things a few years ago, and it’s not as though the policy solutions implemented in the years since have generated a robust economic recovery. Moreover, it’s not as though we don’t continue to have our own issues. The U.S. Congress can't seem to agree on anything to address our own debt and deficit problems.
And our financial sector also has had its share of recent issues including the collapse of MF Global and signs of potentially serious trouble at systemically important Bank of America (BAC). Thinking about things from a different perspective, maybe Germany has it right and we have it wrong. Perhaps actually working to punish bad actors instead of continuously bailing them out with scant consequences might ultimately lead to a better result for the global economy in the end (albeit not without some pain along the way). In other words, maybe Germany won't act with aggressively policy support in the end because they don't think it's in their best long-term interests to do so.
Despite all of the obstacles mentioned above, let’s just suppose that many of these European countries actually carried out the demanded austerity measures. This presents a whole new problem for the stock market, as increased austerity essentially means slower economic growth. With the probability of a severe recession already high across Europe, this would only serve to dampen growth even further. And any severe recession in Europe is going to have meaningful spillover effects into the U.S. and the rest of the world that will further drag on growth. So even if we see bold solutions from European leaders, it will come with a sizable degree of economic pain that makes for a poor stock market backdrop. And any notions that the U.S. economy is sufficiently decoupled from Europe that it can continue its current growth trajectory is misguided. Europe is a major U.S. trading partner, and if European demand is reduced, the U.S. economy will suffer accordingly.
For all of these reasons, I am less optimistic and more pragmatic as we move toward these European policy meetings at the end of the week. Ultimately, I believe hopeful markets will ultimately be disappointed once again. Of course, this doesn’t mean that markets won’t rally sharply higher immediately following any announcements coming out of these meetings, as stocks have shown the tendency in recent years to rally first regardless of what is said only to subsequently fade lower once a hard look is taken at the facts.
In the end, I hope that I am wrong. Perhaps this will finally be the meetings where European leaders do what it takes to begin truly resolving their debt crisis. But I have to be realistic in the meantime based on past precedence and the ongoing challenges of the current situation.
As we move toward these meetings toward the end of the week, the best strategy remains to keep hedges in place. Stock allocations should remain in tact given the possibility for a sharp rally coming out of these meetings or better yet actually substantive policy solutions this time around. Such allocations should already be proportional to other asset classes in an overall allocation strategy and should emphasize more defensive high quality stocks such as PepsiCo (PEP), HJ Heinz (HNZ) and Clorox (CLX) to help smooth the volatility associated with this allocation.
A variety of other asset classes beyond stocks are also provide strong diversification and stand to hold steady if not benefit if the European meetings disappoint later this week. These categories include U.S. Treasury Inflation Protected Securities (TIP), Agency MBS (MBB) and Utilities Preferred Stocks (XCJ, DRU, SCU, ELA). And precious metals such as gold (GLD, IAU, PHYS) and silver (SLV) also offer appeal as a store of value and protection against any potentially aggressive monetary policy action. And if the news out of Europe is unexpectedly disappointing to close the week, defensive U.S. Treasuries (IEF, TLT) should perform well, although this category is otherwise overdue for a consolidation of recent gains.
These continue to be interesting times in investment markets. And the next several days promise not to disappoint in this regard. Stay tuned.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.