Price action in the US stock market has been characterized in the recent past by a dangerous degree of complacency in the face of a major deterioration of economic and financial conditions abroad and domestically. Based on a series of data points and events in the last three days, this complacency may soon collapse and could morph into panic.
Europe Hopes Dashed
As I recently predicted, the enthusiasm generated in the immediate aftermath of the most recent EU summit has very quickly faded and could soon run the gamut from disillusion to fear and outrage.
The most significant event of the past few days has been the general realization that the EU summit agreement reached on June 29th was mostly ineffectual in dealing with Europe's most pressing problems.
- First came the news that Holland and Finland will block use of ESM funds for sovereign bond purchases. Even if such opposition can eventually be overcome in principal, the required conditionality demanded by these and other nations will likely render the ESM ineffectual as a sovereign bond backstop.
- The second blow of the week came when it was disclosed that, due to a series of problems and disputes amongst eurozone members, details of the Spanish bank bailout would not be finalized until July 20 at the earliest.
- A third blow came when Finland announced that it would block any ESM disbursements to troubled countries and/or banks unless the relevant nations posted adequate collateral.
- A fourth blow came when it was reported on Friday that Spain will have to provide guarantees for 100% of funds disbursed by the ESM/EFSF towards the bailout of Spanish banks. Indeed, Spain may be required to post collateral. This development directly contradicts the summit goal of severing the vicious cycle between the Spanish banks and Spain's sovereign debt situation.
- A fifth blow came when the European and world press all of the sudden came to a realization, after statements from a top-ranking eurozone official, that the possibility of the ESM "directly" capitalizing Spanish banks was merely academic. Since the central regulatory institution which is a pre-condition for such aid will not be up and running until mid 2013, at the earliest, and most likely until 2014, Spain will not be able to benefit from this mechanism - at least not in time for it to make a difference.
- A sixth blow came from Finland's finance minister who stated that the Nordic country was prepared to exit the eurozone if it were forced to pay for the debts of other nations. Finland's finance minister stated, in no uncertain terms, that "Finland is not going to stay within the euro at any price."
- A seventh blow came in the form of the realization that help for the Spanish sovereign as well as its banks depends on meeting its fiscal commitments as evaluated by the Troika. Unfortunately, it is now clear to everybody accept the willfully ignorant, that Spain cannot and will not meet those commitments.
- An eighth blow came as Greece's demands for a renegotiation of the terms of its bailout were rebuffed by the IMF and throughout European capitals. The problem is this: Greece's requests can be denied by its European partners; what cannot be denied is that Greece will experience a chaotic default without such a renegotiation and such a development will have serious negative repercussions throughout Europe that are not fully understood or much less fully discounted by financial markets. This reality will soon come to the fore again.
And I could go on, and on.
In sum, the ineffectiveness of the recent European summit agreement on June 29th is being brought into full relief. The sense of disillusion amongst political leaders, investors and consumers will have real impacts in the European macro economy that is transitioning from bad to worse.
US Economy and Earnings Hopes Dashed
The past few days have dealt a blow to the complacency of US investors who apparently were under the impression that the US economy and stock market would "decouple" from troubles in Europe and elsewhere abroad.
ISM manufacturing and non-manufacturing indices in the US surprised strongly to the downside, with the greatest disappointments coming from the survey's leading components such as new orders and backlogs. Retail sales grew at the slowest pace in three years. Finally, non-farm payrolls disappointed consensus expectations, growing at a rate that will increase the already-high unemployment rate in the US.
Based on the recent bevy of negative data, economists are furiously revising their second quarter (2Q) GDP forecasts from a consensus of around 2.0% a month ago to about 1.5% currently. It is my view that these estimates will ultimately prove optimistic as an inventory draw could cause 2Q GDP to dip below 1.0%. Indeed, there is a very real risk that US GDP growth could register a negative print in 3Q.
Many market participants seem to be discovering something that I have been highlighting for some time: Events in Europe and elsewhere abroad have the potential to derail the US economic recovery.
Furthermore, many market participants seem to be coming to the realization that what happens outside the USA has a massive impact on the earnings of S&P 500 companies. Near 50% of all S&P 500 earnings derive from non-US sources - and the figure exceeds 60% if we include the earnings impact of commodity prices that are determined primarily outside of the US. In a recent article, I highlighted the fact that negative preannouncements are running at an extremely high pace and 2Q 2012 is setting up to mark a negative inflection point for S&P 500 earnings.
The recent EU summit supposedly saved Spain. That illusion has not lasted long. Spain's country risk premium (spread to Bunds) is now back to pre-summit levels and Spanish stocks are now essentially back to pre-summit prices. As far as the rest of Europe: The euro is now below its pre-summit levels. Furthermore, most European banks stocks are back to near pre-summit levels - and many are considerably below pre-summit levels.
Notwithstanding these and other problems abroad, US stocks are still levitating based on the generalized notion that the US is somehow immune to the problems in Europe and elsewhere abroad. There is also a widespread expectation that global governments and central banks will do whatever is necessary to prevent stocks from falling.
Recent events in Europe as well as economic data in the US will likely force a reevaluation of the widespread complacency that has been passing for "strategy" in the US investment community.
The transition from complacency to fear will bring about sharp declines in equity indices and their respective ETFs such as (NYSE:SYY) (NYSEARCA:DIA) and (NASDAQ:QQQ). Furthermore, investors should beware of the notion that investors can "hide" in dividend stocks such as McDonald's (NYSE:MCD), or earnings momentum stocks such as Apple (NASDAQ:AAPL), or consumer stocks such as Procter & Gamble (NYSE:PG). In a global economic and financial crisis virtually all stocks will lose significant value and the value of cash will rise in relative terms.
Additional disclosure: Long VXX calls.