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Can The Optimism Continue To Prevail?

Daily State of the Markets
Monday, July 2, 2012

Good morning. Optimism about the future (aka "risk on") was loaded up and locked in the full on position from the time the opening bell rang on Friday until the very last tick of the session. Word that EU leaders had come up with a plan or two to try and deal with the ever expanding sovereign debt crisis was the focal point as French (+4.75%), German (+4.33%), Italian (+6.59%), and Spanish (+5.66%) stocks all exploded higher on Friday. Although details were few and far between and the plans announced did fall short of expectations, optimism that things might calm down across the pond caused yields to dive in Italy and Spain on Friday, which, of course, is reason enough to be optimistic.

Whether or not the optimism surrounding the EU's Summit's Memorandum of Understanding to create a single supervisory mechanism for the Eurozone banking system will last is a question for another day. Although Friday's session was impressive and was likely aided by the end of the quarter pricing shenanigans, even the most ardent bulls will have to admit that the gains did have an "overdone" feel to them across the globe. As such, traders will likely keep one eye on this week's action while participating in the traditional July 4th festivities.

Although optimism remained the word of the day on Friday, I'm guessing there is a fair chance that some skepticism could possibly creep into the markets at some point in the near-term - especially if yields, spreads, and CDS in Italy and Spain begin to move up again. You see, the announcement made by the EU leaders was long on concept and very, very short on details. Oh, and the timing of the whole thing remains a giant question mark as it appears that the earliest point that a "single supervisory mechanism" could be created is by year-end. And for those of you keeping score at home, that's six full months from now.

The issue of concern from a short-term perspective is that of bond yields in Italy and Spain. Don't forget that Italy's PM had said late in the week that his country couldn't keep financing the country's obligations for long at current rates. It is fairly clear that this statement was used as a bargaining chip in order to get EU leaders to act. However, the key points were fairly clear: (1) yields in Italy were quickly approaching the point at which five other countries have required bailout loans and (2) the EU's bailout funds aren't big enough to bailout Italy and/or Spain.

Therefore, both Italy and Spain pounded the table for EU leaders to do something (anything!) to keep rates from continuing to rise. So, as had been widely expected, leaders "talked" about the idea of the current and future bailout funds (the EFSF and ESM respectively) being able to buy bonds on the open market and to recapitalize banks directly. And just like that, optimism took over in the markets.

On the details front, there is one line from the EU's MOU (memorandum of understanding) that really says it all. "When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision have the possibility to recapitalize banks directly."

While true optimists wouldn't spend a lot of time analyzing the fine print, the devil, as they say, is in the details. And although I am a card-carrying member of the glass-is-always-at-least-half-full club, let's dig into that statement a bit. First, as I mentioned, the "single supervisory mechanism" isn't likely to be established until the end of the year - at the earliest. So does this mean that there can be no bond buying or bank recapitalizations by the bailout funds until then? Then there is the use of the word "could" in the statement. Obviously the word was chosen carefully, but even the modest skeptic may find the choice a bit odd. And finally, let's remember that the ESM doesn't exist yet; it hasn't been ratified by all the countries, and doesn't have any funds. ZeroHedge eloquently summed it nicely on Friday with this Tweet, "So, at some point far, far away, banks may be recapitalized?"

The thinking in the markets would appear to be that IF (insert 24-point font here) the "issues" in Europe can be put aside again (recall that this is the third time over the last 2.5 years that stocks have corrected hard on fears about Europe and that stocks eventually moved on to other things each time) then investors may return their focus to the fundamentals. This, of course, would include items such as earnings, economic growth, inflation, and the level/direction of interest rates.

However, with growth clearly slowing in the U.S., Europe, China, India, etc., the question is if the upcoming earnings season will be able to support the current uber-optimistic view. On that note, it is important to note that the current preannouncement season was decidedly downbeat as only 24 of the 125 companies that provided updates to their earnings guidance increased their expectations while 46 cut their guidance. And according to StreetAccount, this ratio is below the levels seen in Q1 and the year-ago period.

Those wearing the rose-colored Revo's will contend that the reduced earnings expectations for Q2 means that the bar has been lowered. And since the earnings game is all about reality versus expectations, the bulls suggest that earnings will continue to be something they can lean on going forward.

So, will another "plan" set in Europe and the earnings season about to begin, the question of the day is if the current optimism can last. While traders and macro players may be placing their bets on the subject, I'm going to stick to my risk management systems. They certainly aren't perfect, but they do help us (a) avoid the big mistakes and (b) keep us on the right side of the important trends.

Turning to this morning... Stock futures are pointing to a slightly higher open on expectations for further easing from the BofE and ECB this week as well as the PMI reports from Europe that showed some modest improvement. However, with the ISM report in the U.S. due out after the open, any early gains are likely to be limited.

On the Economic front... We will get the reports on ISM Manufacturing and Construction Spending at 10:00 am.

Thought for the day... "I skate to where the puck is going to be, not where it has been" -- Wayne Gretzky

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: +0.89%
    • Shanghai: +0.03%
    • Hong Kong: Closed
    • Japan: -0.04%
    • France: +1.59%
    • Germany: +1.33%
    • Italy: +0.82%
    • Spain: +0.32%
    • London: +0.73%
  • Crude Oil Futures: -$1.41 to $83.55
  • Gold: -$15.30 to $1588.90
  • Dollar: higher against the yen, euro, and pound
  • 10-Year Bond Yield: Currently trading at 1.651%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +2.24
    • Dow Jones Industrial Average: +4
    • NASDAQ Composite: +0.58

Positions in stocks mentioned: none

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For more of Mr. Moenning's thoughts and research, visit

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