Stocks have had a pretty bumpy ride over the last three weeks, with the S&P 500 falling exactly 10% from the September 19th high. The S&P 500 cash index, which is what you see quoted on TV and in the paper, fell almost 9.9% but the S&P 500 futures fell exactly 10.0% and turned on a dime once it hit that mark. Either way, it’s close enough for me to consider that the 10% pullback you so often hear about; the one everybody has been waiting for.
The reason why stocks have been so rattled is due to some confusion in the investment markets. We’re seeing contrasting signals between economic data, the Fed’s message, bonds and commodities. While the recovery in the US has been slow but steady, the price of oil has been on a rapid decline since June from $107 to $80/barrel and government bonds have been rallying. Falling oil is definitely a good thing for the consumer, but it’s falling mainly due to demand concerns with the fear of a deep global slowdown. Ditto for why we’re seeing Treasury bonds rally.
You can see that the wildest day last week, Wednesday, was driven primarily by a huge spike in Treasury bonds. Once T-bonds reversed, stocks reversed and started to climb. There were a lot of rumors of forced capitulation with so many institutional investors and hedge funds positioned for rising interest rates (short Treasury bonds) being forced out. It may not look like much, but that’s a really big move for one day:
S&P 500 (top) vs 30 year T-bonds (bottom) – 5 minute chart highlighting Oct. 15th
In my view, the biggest concern and thing I’m most closely watching is Europe. I’ve been saying that a Sovereign Debt Crisis (government bonds) is the next crisis the markets will face and we may be quickly approaching the day or reckoning. Last week we saw German 10-year government bond yields hit a new low under 0.72%, while the 10-year yields of Spain, Italy, Portugal and Greece all climbed higher. This is showing further concern over the Eurozone economy as their Savings and Investment imbalances widen. These imbalances need to be corrected but the EU leaders refuse to admit that there is a problem. Their solution to boost their economy is to force their excess Savings (which is primarily Germany at the expense of the Southern European nations) onto the rest of the world. The problem with this is that the imbalance is really large and the rest of the world isn’t exactly in a position to openly accept it. The imbalance appears to be widening because private investment is dropping so quickly based on a bleak economic outlook and rising unemployment.
But why is the economic outlook so bleak? It all ties back to the approaching Sovereign Debt Crisis. As Europe has unsuccessfully tried a socialist experiment for 60 years now, they’re at the tipping point: governments have too much debt, have promised too much in spending, and with a falling economy don’t have enough in tax revenues. (Although, we should be honest, no economy can ever grow quickly enough to generate enough revenue to satisfy a government…) Their solution is to force austerity and raise taxes, which is inevitably creating a downward spiral as they further worsen the economic situation and force private capital and investment to flee as quickly as possible – which is creating their large imbalance that they hope to force on the rest of world.
What we care about as investors is what will happen next, and this will be determined by Europe. We’ll throw the best solution of breaking apart the Eurozone off the table because they’ll never admit it’s a flawed structure, which leaves us with what Europe ultimately decides to do to correct the imbalance. If they were to correct the imbalance internally instead of forcing it on everyone else, they would experience a long and slow, but necessary, correction. This would actually be the least painful option but we can’t expect a politician to make the right long-term decision when it looks bad in the short-term. If they choose to invest their savings outside of Europe, it will depend on where. Unfortunately we’re seeing a large portion continue to flood into the US which will not be helpful for the global economy. The US has all of the financial resources we need to create money for Investment; other less developed nations do not. Europe forcing their Savings on the US is essentially asking the US economy to pick up Europe’s lack of demand. This would ultimately slow the US economy and raise unemployment. Unfortunately this is what we’re currently seeing at a time when the world needs a strong US recovery. If they continue to ignore the problem, the imbalance will ultimately correct itself in the form of a very nasty collapse because an imbalance cannot continue forever.
All too often these situations have ended in major debt restructurings and it appears we’re set on that path once again. Thank you, politicians… As more investors are starting to see the writing on the wall, it’s possible we could actually see US stocks and corporate bonds accelerate to the upside as the safest place to invest. I’ll be keeping an eye on European capital flows – they’re currently the key to the global economy and investment markets.
As a side note, in the short-term it appears that stocks have put in a low. We could see another drop to test the lows (creating a bottom is more of a process than a one day event) but I’m not expecting a large drop beyond that. We should hit the major point of resistance today/tomorrow that will tell us if we’re on the next leg higher or if we need to spend a little more time bottoming out.
As always, thanks for following!
-Nick
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