Update On U.S. And European Markets

Includes: DIA, QQQ, SPY
by: Jeremy Robson

Markets have been diverging lately. Spain and Italy are down over 11% in the last 4 weeks. The S&P500 is presently only 4% below its recent peak.

The U.S.

I have been writing that I expect the next leg of the bear market in the U.S. at any time, and have so far been wrong. The main reason for my bearish stance is that I believe fiscal stimulus is off the table for all Western economies, and monetary policy is weak at the zero bound of interest rates. The U.S. budget deficit for fiscal 2011-12 is going to come in somewhere between $1.2-1.3 trillion, almost exactly where it was for the previous fiscal year. There has been no sign of fiscal consolidation so far, but it cannot be far off. The present economic data have been weak, but not yet signaling recession. I estimate that growth has slowed from the 1.7-2% range to around the 1% level. This is based on the weakening in new orders, slower industrial production and ISMs (both manufacturing and non-manufacturing).

However the supporting data of rail traffic, port imports/ exports volumes, trucking volumes and withholding taxes have all held reasonably steady, at very low levels of growth. The first read on 2nd quarter GDP comes out on Thursday. The level of GDP will be very dependent on the level of the GDP deflator. If the deflator is lower, growth will be higher, and vice versa. I would suggest examining both, for a good read on the growth figure. I recently read this article from the Wall Street Examiner regarding the trend in new unemployment numbers. The article links to withholding tax data and comes to the conclusion that the data have not yet broken to the downside (although it does suggest it is close to breaking). I may be wrong in my favor, but it seems early for a recession without the fiscal consolidation that I have been waiting for.


When things get really bad in Europe, there will be another summit with lots of supporting statements. The market has not failed to rally on any of the summits, so far. We seem to be in the time when market worries dominate. These periods have typically been followed by some policy action that relieves the tension. I would suggest that the political situation will have to have deteriorated significantly for there to be no response to the next crisis. The ECB, although reluctant to restart their sovereign bond purchases, will surely jump in if rates fall off a cliff. None of this is a solution. If the Eurozone is to stay together, the periphery nations are going to have to go through internal devaluations that are all over 20% (The Telegraph). There is a good article by Cam Hui on the long term European plan. At present, Greece has completed an internal devaluation of around 12%, and is three quarters done, Spain has only completed around 9%, and Italy has not really begun. Ireland has also completed three quarters of the required devaluation. Here is a useful kink to the update on internal devaluation progress from May 2012. They suggest:

INTERNAL DEVALUATIONS % of devaluation required
Ireland 23.5 75
Greece 11.4 78
Spain 8.9 51
Portugal 3.2 30
Italy 0.6 4
Click to enlarge

Note: These devaluations restore the position back to the start of the Euro. They do not completely eliminate the uncompetitive positions of the periphery nations.

The crisis will roll on until these devaluations have completed and the sovereign debt levels have been reduced to below 60% of GDP for all of the periphery nations. In the 3 1/2 years since the crisis began, internal devaluations for the whole Eurozone have not yet reached the half way mark. There are several years of crisis left in Europe, if there is no breakup of the Union (which is another topic entirely).


So what about markets? I read this article by the Hard Trade on Seeking Alpha regarding European bourses. Looking at the above, despite the good analysis in the article, I believe this article's call is at least 2 years early. It is an interesting article, though, and it uses CAPE and Tobin Q valuations, which are much more reliable. Europe is not for me yet, although it will likely be my first buy. The Europeans are getting on with fixing their problems, even though they have a long road to travel. I expect European markets to remain soft for some time yet, as the solutions to the problems are nowhere near complete.

I remain bearish on America for the next 2-3 years. The U.S. recession looks set for 2013, as some fiscal consolidation comes out of the fiscal cliff. I am still thinking that $100-150 billion is taken out of the budget deficit for 2013. This will be enough to bring on the recession. QE3 is coming, but I continue to believe that it will not juice markets as it has done in the past. The backdrop is now not so favorable. Earnings growth is down to less than 3%, and the world economy is slowing. These are not the same conditions that QE1 and 2 were launched in. America will eventually be forced into facing their budget and entitlement problems, unless they wish to repeat the Japanese model. In the time up to the presidential election, the U.S. market may hold up, but I cannot see a rise, with the present backdrop. The past 2 years of seasonality would suggest a different story, however. This pattern is holding me back from outright bearishness. A sideways trade seems logical, with lots of volatility. I am not so sanguine about 2013. For the more bullish readers, I recently wrote of my worries concerning my bearish trade. If you don't like this article, the linked one may be more to your taste.

Disclaimer - This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.

Additional disclosure: Long (NYSEARCA:RWM), (RIMM), various U.K. corporate bonds, (NYSEARCA:USD) and (JPY(