A Dead End For Europe?

Includes: EWG, FXE, IEF, SPY, USO
by: Wall Street Sector Selector

by John Nyaradi

Thursday's summit could be the end of the road for Europe.

Thursday's and Friday's European summit in Brussels will be another pivotal event in the ongoing debt crisis, as leaders try to get a handle on the rapidly deteriorating situation across the European Union. Italian Prime Minister Mario Monti said last week that Europe has a week to save the eurozone and we can expect more volatility as the meeting approaches.

Markets will also be affected by significant economic reports due to be published, tensions between Turkey and Syria over the shoot down of a Turkish fighter jet in international airspace and the Muslim Brotherhood winning the Presidential election in Egypt.

On My Wall Street Radar

chart courtesy of StockCharts.com

In the chart of the S&P 500 (NYSEARCA:SPY) above, we can see how the index rallied sharply in June, powered by hope for more quantitative easing to be announced at last week's Federal Reserve meeting. However, the Fed disappointed with its modest extension of "Operation Twist" and markets reacted strongly with Thursday's sell off.

Now we see declining momentum in most indicators, with RSI and MACD both turning down.

On a longer term basis, we see the 50 day moving average rolling over to indicate an intermediate downturn as the index was unable to hold the 50 day moving average and starts to converge with the 200 day in a potential death cross formation somewhere in the near future.

However, significant support rests at the 1310 level as indicated by the horizontal red line, and more support is found at the 200 day moving average at 1295, so these will be key levels to watch over the next few days and weeks. A break below these levels would heighten the probability for more downside action ahead.

Click to enlargechart courtesy of StockCharts.com

In the chart above we see the S&P 500 compared to West Texas Intermediate Crude Oil (NYSEARCA:USO). We can see how the two have been tracking quite closely until mid-May, when oil began a precipitous decline and the S&P 500 started its hope induced rally into last week's Federal Reserve meeting. The outcome of no more QE for now disappointed markets, which took a sudden downturn, and now the S&P 500 and oil need to reconcile this divergence in prices.

Either oil needs to rally strongly or the S&P 500 is due for a correction to approximately the 1125 level, some 15% from current levels and 20% from recent highs. Oil is pricing a significant global economic slowdown which is confirmed by U.S. Treasuries (NYSEARCA:IEF) which remain close to all time highs.

The Economic View From 35,000 Feet

Last week's economic news was trumped by the market's disappointment in the Federal Reserve when the board opted for a modest extension of its "Operation Twist" program to extend into the end of the year. Clearly markets were hoping for another round of quantitative easing, and equally clearly, Dr. Bernanke and his colleagues chose to keep their powder dry in the event of more unrest / uncertainty in Europe. Clearly, Dr. Bernanke and Company are doing more talking than acting as they run out of ammunition and every shot has less impact on markets and the economy.

The situation in Europe continued to be chaotic as Greece formed a new government. But two of its top leaders, the Prime Minister and Finance Minister, encountered medical problems and so won't be attending this coming week's European summit in Brussels where Greece is expected to ask for a two year extension of the deadline to meet its already agreed to austerity program. This is unlikely to sit well with Germany, which is loudly saying that there will be no changes to the deal and that Greece needs to put up now. A recent poll in Europe showed more than 75% of Germans want Greece to leave the European Union, along with a majority of French and Spaniards. When push comes to shove in Europe, and that is coming soon, it will be every man for himself.

In Germany, the DAX declined sharply on Friday and iShares MSCI Germany Index EWG) was off 3.5% for the week. The Eurodollar (NYSEARCA:FXE) declined for the week to $1.257. The good news was that Spanish bond yields fell and Italian bond yields remained stable in spite of continued pressure on the two countries, particularly Spain, which is due to formally ask for its bank bailout on Monday.

Manufacturing and confidence indexes in Germany dropped with the country's PMI hitting a three year low and its business confidence index hitting a two year low. Things were worse in Italy, with consumer confidence dropping to record low levels.

In China, the HSBC June manufacturing gauge continued its fall, logging in at 48.1, still in contraction territory and a low for the year. Meanwhile, at home the Philadelphia Fed took a significant plunge to -16.6-- widely missing expectations, along with initial unemployment claims coming in at 387,000, also above estimates.

Back to Europe, the "big four, Merkel, Monti, Hollande and Rajoy, met in Rome last week in preparation for this week's European summit and came away with a proposal for a growth plan good for $160 billion, which is approximately 1% of the European Union GDP. Dr. Merkel and French President Hollande meet again this Wednesday to prepare for Thursday's summit.

Meanwhile, Spain will come looking for 100 billion Euros on Monday to recapitalize its ailing banks while Mario Draghi is relaxing collateral rules for lending to its troubled members.

The week ahead will bring the European Summit on Thursday and Friday, along with significant economic reports all week. Monday brings the Chicago Fed and new home sales reports, Tuesday unveils Case/ Shiller housing prices and consumer confidence, Wednesday shows durable goods and pending home sales, Thursday highlights Q1 GDP, and Friday wraps up the week with personal income, spending, Chicago PMI and University of Michigan Consumer sentiment.

Bottom line: Expect significant volatility ahead as Europe runs out of road and the global economy slows. As always, danger arrives holding hands with opportunity and current days are no exception.

Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.