Cliff Wachtel's  Instablog

Lessons & Ramifications for the Coming Week

Part 1 of Weekly Review/Preview: Prior Week Market Movers & Their Lessons For the Coming Week

The following is a weekly summary and strategy guide for traders and investors, covering prior week's market movers and their lessons for the coming week for traders of all major asset classes via both traditional instruments and binary options.

See Part 2 for our weekly review of what to watch for the coming week.

In last week's weekly preview, we warned that our perception about the state of the global economy could change this week. It did, and markets have shown signs of recognizing that the tight trading range on the bellwether S&P 500 was a prelude to pullback and not a further rally.

For most of 2012, despite building evidence of a global economic slowdown and continued deterioration in the EU (despite the ECB's LTRO band aid), risk assets, including the EUR, have been surprisingly resilient.

Risk assets just suffered their worst overall pullback in 2012. Why, and what are the lessons for the coming week and beyond?

First let's take a brief look at the highlights

Monday: Bad EU, US Data, Spain Worries Drive Markets Lower

With both Japan and China closed for holidays, the focus was on Europe and the US. Risk assets sold off in both markets, with Europe especially hard hit with major stock indexes down between 1.6% to 2.4%. Driving markets lower were the following reports:

• Germany: retail data misses forecasts
• Spain: GDP contracts for the second straight quarter, putting it officially into recession, its banks' credit rating was downgraded by S&P after its sovereign rating downgrade last week. Spain now joined 10 other European nations in entering a double dip recession, further complicating its ability to narrow its budget deficit by 3.2% this year as its tax base shrinks and joblessness rises to ~25%, ~ 50% for youth.
• Adding to the gloom, a number of analysts noted that the Spanish banking system has crossed the 10% threshold of funding from the central bank - a level at which private markets become unwilling to provide further funding.
• US: Personal spending down, core PCE price index up (hotter inflation makes QE 3 less likely), Chicago PMI mfg data misses forecasts.

Tuesday: With Asia Mixed & Europe Mostly Closed, US USM Manufacturing Beat Brings Modest Rally

• Asian markets were mixed on conflicting data. A surprisingly large 0.5% RBA rate cut lifted Australian stocks and pounded the AUD. Meanwhile China and UK both posted lower manufacturing PMIs, confirming earlier signs of slowdowns in both countries.. Europe was mostly closed for May day.

• That left the US as the only fully liquid market. Given the importance of the Friday monthly jobs reports, it focused on the upbeat ISM manufacturing PMI data, which bode well for Friday, and rallied modestly, ignoring the negative Chinese and UK data.

Wednesday: Risk Asset Resilience Despite Wave Of Bad Data Worldwide

• Except for Asia, which rose on delayed reaction to the US ISM data, risk markets fell on a deluge of bad data. Highlights included:

• In Europe, we saw a rise in German unemployment (only the second in the past 15 months), a drop in its revised PMI figures, and a slowdown in Italian manufacturing activity. The news caused a roughly 100 pip drop in the EURUSD from its 1.3200 level that shattered the pair's month long uptrend, leaving it vulnerable to a test of 1.3100 or lower. UK construction PMI also fell, though less than expected. The big takeaway between the German jobs and PMI data was that it supported the fear that weakness has hit the EU's core.

• In the US, a weak ADP NFP jobs report, ominous for Friday's official BLS jobs report, as well as a drop in factory orders added to the bad news from Europe.

• Yet except for the EUR's 0.75% drop, and stock indexes in Spain and Italy falling ~ 2.5% for the second straight day, risk assets showed only minor pullbacks.

• Indeed, the prior day had shown manufacturing PMIs falling throughout Europe, as well as in Asia, Brazil and most other emerging markets that had reported. Only Turkey, India, and Russia reported modest increases.

• One under the radar factoid worth noting: Goldman Sachs noted the significance of April's plunge (-16.7%) in South Korea's exports to Europe (U.S. +5.6%). It called Korea the "canary in the coalmine" because it releases export data earliest and has a high correlation to the rest of Asia.

Thursday: Market Resilience Broken By Uncertainty Ahead of US Jobs Reports, ECB Restraint, Bad Data

Then came Thursday, and the market resistance to the waves of negative data broke down. Over the next 48 hours the bellwether S&P 500 decisively surrendered both its 8 session uptrend and the significant 1400 level, falling to month-long support around 1360 to close its worst week in 2012.

• Asia: Mostly sold off ahead of holidays and uncertainty ahead of the ECB meeting and US jobs reports,

• Europe: Risk assets were mostly lower after the much anticipated ECB meeting offered no signs of coming easing measures. While Spain was able to sell €2.52 bln in three and five year bonds (beyond it's expected amount), yields were 100-150 basis points higher.

• US: Risk assets sold off after bad jobs news hit that cast further doubt on Friday's official monthly employment reports. The April ISM non-manufacturing index missed expectations. The jobs component of the report is considered among the best indicators of how the Friday reports will pan out, because most US jobs are in services rather than manufacturing.

Friday: Another Bad Monthly US Jobs Report

• Asia: Mostly closed modestly lower on uncertainty ahead of the US jobs report and weekend elections in France and Greece, both of which could produce market moving reactions Monday.

• Europe & US: The combination of the poor US jobs figures and uncertainty about the French and Greek elections sent virtually all major European risk asset markets lower about 2% lower, and US markets about 1.5%. Crude oil fell nearly 4%. The jobs figures were bad enough to dent market confidence, but not bad enough to raise hopes of coming stimulus, which many believe is the only compelling reason to believe that markets could rally further. This same "bad but not disastrous" view that sunk stocks helped the USD because it raised demand for safe haven assets without materially raising hopes for new stimulus (which would weigh on the USD).

LESSONS AND RAMIFICATIONS: Markets At The Brink

The biggest lesson of the week: we haven't gotten our signal yet to start shorting, but we're really close. Here's how we see things.

Ok, bad data and EU uncertainty hadn't stopped markets from rising or holding steady thus far in 2012, so what changed?

THE FUNDAMENTAL PICTURE: FUNDAMENTALS WEIGHING ON MARKETS THIS WEEK

The week brought a particularly toxic combination of:

• Bad Data In Both Quantity and Quality: We had an exceptionally large wave of significant manufacturing and jobs data this week. The US and China are slowing, most of Europe is too, or tipping into another recession. The US jobs reports, arguably the single biggest calendar event of the month, showed labor participation falling and wages stagnant. That means consumer spending, the biggest component of US GDP, is likely to worsen.

• Continued Rising GIIPS Bond Yields: Meanwhile, GIIPS bond yields keep rising higher, complicating their ability to buy time by loading up on more debt, and weakening their banks, which have been loading up on these now depreciating bonds via the ECB's LTRO program.

• Already Dour Context: All this comes after the prior week, which brought news of Spain and the UK back in recession. Spain is obviously a huge concern for the EU as the likely last stand for the EU and EUR as we know it. The UK too is significant, because its struggling even though it has the freedom to print if needed, showing that the slowdown is more than an EU affair.

• Exceptional Political Risk: Elections in both France and Greece could be exceptionally damaging to the EU's outlook:

• France: The likely result, a victory for the socialist Hollande, is expected to weaken the Franco/German EU leadership at a time when the ability to act in a united and decisive manner is more needed than ever as Spain and Greece teeter at the edge of the economic abyss.

• Greece: There is a very real possibility that the election result in enough opposition party strength to prevent Greece from meeting the conditions needed to get further bailout money per the IMF's Memorandum of Understanding (which some of these parties have not signed). If that happens, risk of a Greek default and contagion across the EU periphery rises. Greece has until June 30th to make the additional spending cuts.

• So this election risks setting into motion a range of unsettling events, including a Greek EU exit and periphery-wide contagion as credit markets jack up borrowing costs to the GIIPS to compensate for the added default risk. These of course risk becoming self-fulfilling, if bond yields demanded from Spain, Italy, and Portugal become too high and the EU's bailout funds become quickly overwhelmed without new money printing, to which Germany could well object.

THE TECHNICAL PICTURE: BENT BUT NOT BROKEN

As we've been saying for a while now, risk assets like the S&P 500 index being at multi year highs made them vulnerable to disappointments. The accumulated weight of bad data may have finally caught up to them.

Here's the S&P 500 weekly chart for perspective, followed by a few key observations.

S&P 500 WEEKLY CHART DECEMBER 2009- APRIL 2012

Source: MetaQuotes Software Corp, globalmarkets.anyoption.com 01 may 06 0020

Bearish Signs

We have a nascent downtrend forming over the past 5 weeks

For the 4th time in 5 weeks, the index is now decisively below its Double Bollinger band buy zone, meaning the upward momentum of the rally that began in September 2011 is likely finished

The 10 week (blue) and 20 week (yellow) EMAs are flattening out, another sign of lost momentum

Bullish Signs

Key support for 2012 around 1360 has held.

CONCLUSION

We've said for weeks that despite the bearish picture we wouldn't be shorting risk assets until we see signs of a trend reversal. We still don't have that until we get a decisive move below 1330, which would take us below the support of the 20 week EMA. Only then can we say that the uptrend is not merely bent but truly broken.

If we get that signal, here are some assets to consider shorting:

Guiding Principles

Look at assets related to the EU, the epicenter of the trouble, then China, or more likely Australia, as its markets are generally an easier play on China. The US remains the least dirty shirt in the hamper for now.

Major Stock Indexes

Check your charts for which particular index offers the best entry points, as most move in the same direction.

Commodities

• Oil: In general, crude oil tends to exaggerate the moves of the major stock indexes, so depending on your time frame, WTI or Brent crude charts (or their ETFs) might offer lower risk entry points.

• Gold: Reflecting the fact that is NOT a risk asset, it has held within its tight trading range this week. However it's unlikely to make a move higher until we get a new bought of fear about the EUR's continued existence as we know it. If so, we'd be looking to be LONG gold, though we haven't yet set what kind of break higher we'd need to see to suggest a new uptrend. Stay tuned.

Forex

If things break down the only question is, which of the 3 major safe-havens, the CHF, USD, or JPY do you like most vs. the highest risk AUD, NZD, or EUR? We would not be shorting the CAD right now (a separate discussion). If fear gets extreme, the USD is the obvious choice. If not, the answer depends on whether the BoJ and SNB continue to strive to keep the JPY and CHF low. The most likely scenario is that in the next bout of EU crisis, the SNB could be forced to abandon its EUR purchases and CHF sales that fund them, and the CHF could spike hard and fast.

Alternatives To Play All The Above: ETFs & Binary Options

Those without forex or commodity accounts can play these via the ETFs, but, check how the ETF is structured to be sure you know what you're getting.

Alternatively, the simplest way to play a forex trend is via forex binary options. We prefer only those with weekly or monthly expirations, because they give the fundamentals time to play out, so stick to brokers that offer these, like anyoption.com (full disclosure, I provide content for them). Daily forex trends are harder to forecast, so be careful about binary options with shorter expiration times.

Binary option accounts can often be set up and funded very quickly, so don't let you're not having an account stop you.

Don't Neglect Currency Diversification

No prudent investor would have everything in one kind of asset class or sector. With most major central banks actively weighing when to begin further rounds of stimulus or rate cuts that risk cutting the purchasing power of their currencies, it's equally foolish to have everything you own denominated in one currency. Bernanke & Co. think we must just accept their stealth tax. No so.

Getting that diversification needn't be complex, nor risky, if you're prepared. Here's your best source for simpler, safer ways to do it: is THE SENSIBLE GUIDE TO FOREX, SAFER, SMARTER WAYS to SURVIVE and PROSPER from the Start. It's the first book to show how both prudent active traders and long term investors with limited time and risk tolerance can tap forex or commodity markets to hedge currency risk and improve returns. See my profile page or the above link for details. Call this naked promotion, but I feel like the guy selling lifeboat reservations on the Titanic. A minor annoyance, until suddenly…. Better to be safe than sorry.

DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN'T BE TELLING YOU FOR FREE, NOW WOULD WE?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.