Greece, M2, And Dow Theory All Suggest Big Trouble Ahead For Markets

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Includes: DIA, EU, GREK, QQQ, SPY
by: Mayer Winkler

Summary

Both the S&P and the Dow have been meandering since February.

Europe and China are doing worse, with Grexit on our doorstep and no precedent to compare it with.

Dow Theory is also signaling danger with transports in decline, and momentum slowing.

If a bond rout infects Europe on Grexit and it is not contained quickly, things could escalate to the downside fast.

Since February, the S&P (NYSEARCA:SPY) has been drifting up and down in a 50 to 60 point range. The Dow (NYSEARCA:DIA) has been wobbling in a 700-point range just as well. The Nasdaq (NASDAQ:QQQ) is doing better at new highs since 2000, but we'll see if it can break through. In Europe, things are worse. The DAX in Germany is trading more than 10% off its April highs. China's Shanghai index is off 10% in the last 5 days. We are almost seven years into a raging global bull market, and reaching the point where half predict there's not going to be another crash, while half preach impending doom. This time around it is difficult not to side at least partly with the doomsayers in saying things aren't rosy.

A number of factors are coming into play that suggest that the recent drifting we have seen in the major indices could lead to much more than just a correction, and could signal a longer-term reversal in market direction. So, with this said, what are these factors, and how can we interpret them?

First up, let's look at Europe - and in particular, Greece. The situation in Greece is pretty much household news at the moment, and the chances of a Greek default are looking more and more likely every day. Grexit may only be days away now. FT published a timeline earlier this week with the latest "drop-dead deadline" being July 20th. Greece delayed its earlier IMF debt payments by a few weeks at the beginning of this month, through combining four payments into one due at the end of June. It has since publicly admitted it does not have the money to pay them without sealing a deal with its creditors, which looks almost impossible at this point.

The parties involved are still very much in a state of discord, and, in the words of Jeroen Dijsselbloem, leader of the Eurogroup area of Finance Ministers, Greece is moving in the direction of Grexit. While that itself is not news, Dijsselbloem saying it publicly is.

But markets only seem to be meandering on the possibility. They are not fully accounting for the consequences of such an exit. But this is really an unprecedented situation, and nobody has any parallel example to use as a guide for what might happen next. No country in modern times has ever started over monetarily from a currency it could not print to devalue. To suggest that the wider Eurozone would suffer minimal effects from a Greek default seems very narrow-minded, and Greek Finance Minister (or Lack-of-Finance Minister) Yanis Varoufakis agrees.

For one thing, all of Greece's creditors would be forced to write off all Greek debt assets, possibly leading to a bond dump from the weaker Eurozone countries like Italy and Spain. A knee jerk bond rout will almost certainly happen in the weaker Eurozone countries. The question is how long will it last and can it be controlled once it starts. If it's not contained very quickly, global bond markets could get routed, raising interest rates across the globe. The fact that German Bunds have been so weak lately illustrates that investors might not move to safer government paper, but just abandon bonds altogether.

Some analysts are suggesting that because it is largely the public sector that holds the risk rather than the banking sector (Eurozone government exposure to Greek debt totaled €302 billion in October last year) this offers some shielding for the Eurozone. However, at a time when European governments are trying to rein in spending, the writing off of one third of a trillion Euros from the asset side of their balance sheets will do little to improve Eurozone economies.

There is also the potential for wider bank runs than many expect. A Greek default will almost certainly lead to a bank run in the nation - indeed the Greek people are already in a bank jog withdrawing €2B in the last 3 days, which could turn into a full blown bank run by Monday if talks break down again. With no deal in sight, it is hard to see why the ECB would continue upping its lifeline to the Greek banking sector if Grexit is only a few days away.

What will really happen, nobody knows. The only thing we can say for certain is it is not going to strengthen already waning equities markets around the world.

Now let's jump across the Atlantic and look at what's happening in the US. As already mentioned, the major indices are drifting since February. We are seeing a slowing of momentum in the share prices of the constituents of the major indices. Consider the Dow for example. At the then closing record high on February 27, 172 NYSE listed stocks hit new 52-week highs, while 31 hit 52-week lows. Fast forward to May 19 (the latest record close), and the number of companies hitting highs was 118, with those sitting lows 38.

Concurrent to this loss of momentum, we are seeing money supply growth weakening. Weekly average M2 reported has not increased for an entire quarter. An increase in the money supply in an economy will generally translate to increased economic activity in the short run and in turn rising equities markets. Lack of money growth will lead to drifting markets, as we have seen since February.

Dow Theory

Sticking with the US, let's have a look at things from a traditional technical perspective and consider Dow Theory. One of the fundamental aspects of Dow Theory is that for a sustained upside run, new highs in the Dow Jones Industrial Average must be concurrent to new highs in the Dow Jones Transportation Average. This is based on the premise that as industrial activity picks up, the transportation network required to shift resources and finished goods from one location to another should also pick up. Indeed, we have seen fresh highs in the Dow Industrial, but the transports are a different story.

As the chart illustrates, the transportation average has already turned to the downside, carving out fresh year to date lows at the end of May, and looking likely to reach even lower levels over the coming couple of days. From a technical perspective, this suggests that we could be due a major correction in US equities markets, and perhaps even be looking at the beginning of a long-term decline.

Finally, it is worth pointing out that all this is taking place while interest rates remain virtually zero and investors jittery about the first rate hike with September looking likely. Six years into a recovery interest rates should be much higher. While interest rates remain at record low for record long, the Fed has no tools at its disposal to counter an economic downturn this time, meaning the impact of any decline could be far more severe and drawn-out than we have seen in the past.

Conclusion

We are heading into uncharted territory, Dow Theory suggests weakness, markets are meandering, and a financial bomb is about to be set off in Europe with nobody knowing how big the explosion will be. If things take a turn for the worse, those that normally take action to counter a downturn have little to no tools at their disposal with which to do so this time around. Run for the hills? Not yet, but if we do start to see a bond rout in weaker Eurozone countries next week infecting other bond markets globally, it might be a good time to start lightening positions.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.