Short Takes

You have to take any comments relative to Europe with a grain of salt, but the source of the tweet below is credible.

As we outlined in the past, the levels of debt in Europe relative to tax revenues and capital needs for insolvent banks produce an unsustainable situation. Any additional funds given to Greece will most likely have similar outcomes to a flush of a toilet in the coming months. According to Bloomberg (01/28/2012), the Germans seem to agree:

Lawmakers from German Chancellor Angela Merkel’s coalition rejected increasing aid for Greece, Der Spiegel said, citing members of the parliament in Berlin. There can be no further aid if Greece doesn’t implement the agreed adjustment programs, the magazine said, citing Horst Seehofer, chairman of the Christian Social Union, the Bavarian sister party of Merkel’s Christian Democratic Union.

Recent reporting from the Guardian also seems to hint at a greater probability of default than what is priced in the financial markets. Excerpts from a January 25 Guardian interview with Angela Merkel are below:

Angela Merkel has cast doubt for the first time on Europe’s chances of saving Greece from financial meltdown and sovereign default, conceding that Europe’s first ever multibillion euro bailout coupled with savage austerity was not working after a two-year crisis that has brought the single currency to the brink of unravelling.

“We haven’t overcome the crisis yet. Of course, there’s Greece, a special case where, despite all the efforts that have been made, neither the Greeks themselves nor the international community have yet managed to stabilize the situation.”

“There would be no point in promising more and more money without tackling the causes of the crisis,” said Merkel. “Amid all the billions in financial assistance and rescue packages, we Germans also need to watch that we don’t run out of steam. After all, our capacities aren’t infinite, and overstretching ourselves wouldn’t help us or the EU as a whole.”

Note the ongoing mention of Greece being a “special case” in an attempt to stem the almost inevitable tide of contagion. As we showed graphically on January 27, the ever-increasing yield on Portuguese bonds is indicative of a market that also believes Portugal will be a “special case”. Euromoney also expressed concerns about contagion:

As we noted in a December 2011 video, the debt burdens in Europe have moved into unsustainable territory. Europe, with the exception of the U.K., did not recapitalize their banks in 2008, which means at some point more money will be needed to “solve” the crisis. Even Germany’s finances look troublesome if you factor in bank recapitalizations. Therefore, it is not surprising that as the situation in Greece comes to a head, the market is already moving toward the next problem, which appears to be Portugal. From MarketWatch:

Fresh worries have been raised over the potential of a second bailout for Portugal amid concerns the country may not be able to get financing on the open market next year. According to an article in The Wall Street Journal on Tuesday, there are concerns that the International Monetary Fund could make fresh demands on Portugal if it becomes clear it can’t return to the market, which it must do next year to help repay €9 billion ($11.64 billion) in debt due Sept. 2013. Bond yields and the cost of insuring Portugal against default are at record levels, and investors are worried holders of the country’s debt will suffer losses, the same as in Greece.

If the problems in Europe were being overstated and exaggerated, why has it been so difficult to find solutions? The answer is the problems are very serious. Even after all the “rescues” for Greece, this is the state of affairs as summarized in the Wall Street Journal:

BRUSSELS—European Union finance ministers resumed their meeting Tuesday amid rising concern that a proposed deal to restructure Greece’s private-sector debt won’t be enough to put the country back on a firm fiscal footing.

Based on discounted cash flows, the current proposal will write-down 60-70% of the debt held by the private creditors. Think about that - a 70% writedown “won’t be enough to put the country back on a firm fiscal footing.”

Another in a long series of “final” deals with Greek creditors may be announced in the coming days. If that is the case, it is possible the “good news” will result in a buying climax in the stock market. Over the past nine months, the market has tended to anticipate the next deal or summit in Europe, only to sell-off a few days after “good news” has been delivered.

The Financial Times reports why an announcement of a deal with creditors may mean little:

We have mentioned some reasons to be open to a bounce in the euro (DeMark daily, weekly divergences). It is possible the weekly chart of the euro casts some doubt on the euro “bounce” scenario. The weekly chart of the euro ETF (FXE) experienced a DeMark combo buy setup the first week of January. However:

1. The weekly DeMark wave count shows FXE (euro) to be in wave 3 down (strong bearish trend), which is not an optimal time to trade a 9-buy setup.
2. The weekly euro buy setup also occurred below the TDST support level based on the sell setup that occurred in March 2011. The violation of TDST support prior to the buy set up also casts doubt on a lasting reversal in the euro. The break of TDST support implies the bearish trend may be strong enough to continue to the TD weekly countdown 13.

Given the current stance of the dollar, euro, VIX, and S&P 500, we will remain open to numerous outcomes, including a rally in the euro. For now, we will remain patient and see how things play out.

On December 28, we noted action in the euro and U.S. dollar would influence risk assets. The U.S. Dollar ETF (UUP) has failed to recapture 22.62 and closed below its 20-day moving average today, which may point to further gains in stocks over the coming days/weeks.

The euro is trying to find a short-term bottom. On Tuesday it broke above the trendline from the late October highs. We are not bullish on the euro long-term, but countertrend rallies are to be expected from time to time.

When the ECB is expanding its balance sheet relative to the Fed’s balance sheet, the blue line falls (see chart below); under those conditions, the red line shows the euro tends to be weak vs. the U.S. dollar. Chart from Forex.com.

Obviously, if the Fed announces another round of QE, the blue line’s bearish trend can be reversed quickly, which would exert downward pressure on the greenback. We noted on December 29 some reasons to remain open to a euro bounce and some levels to watch.

All the details of Thursday morning’s bond auctions in Italy can be summed up via the yield on 10-year Italian bonds. Despite what some are terming a “successful” bond auction, the yield on the 10-year is rising today; it sits above 7%. The significance of rising yields in Italy is explained at the 13:30 mark of this December 18 video.

Falling in line with Italian bonds, the euro is making new lows again on Thursday morning. As we mentioned Wednesday, we plan to exercise some patience with all positions until we see if the euro continues to drift lower. A good line in the sand is 127.07 on the euro ETF (FXE); a drop below that level would move us closer to deflationary/bearish posturing in the short-to-intermediate-term. If FXE holds above 127.07 and can retake 130.29, we would become more bullish on stocks and bearish on the U.S. dollar (UUP).

In the daily chart above, notice the MACD histogram shows a somewhat tepid move lower, similar to the period near the October low in the euro. We are not bullish on the euro, but we want to see how things play out over the coming days. It would not be surprising to see the euro experience a big move, up or down, in the coming weeks.

The best way to monitor the sustainability of the current push higher in stocks (SPY) is to keep an eye on the euro and U.S. dollar. The correlation between stocks and the euro has been strong in recent months. In the current environment, when the euro strengthens, stocks tend to come along for the ride.

On Wednesday morning, the euro made a new low (see below). If the euro fails to recapture 129.87 in the coming days, it may signal another round of weakness for stocks and commodities.

The weekly chart of the euro is telling us to keep an open mind about the possibility of a snap back in the euro. The euro has clearly made a lower low (see downward sloping red line below), but the technical indicators (ULT and MACD histogram) have made higher lows (see green lines top and bottom). The divergences between price and the indicators may be indicative of a weakening desire to sell the euro (emphasis on may).

Since ETFs are a little easier for the average investor to follow, we will focus on the euro and U.S. dollar ETFs below. If the euro ETF (FXE) fails to recapture 129.34 in the coming days and weeks, it will lean bearish for stocks and commodities.

Looking at ETF volume, we see above average interest in the U.S. dollar. Since volumes are light this week, we will use the S&P 500 ETF (SPY) as the baseline. SPY has traded 46 million shares as of 11:30 a.m. ET on Wednesday, or roughly 19% of a typical full trading day. UUP has traded 77% of a typical day’s volume; FXE 45%.

As outlined on December 18, we do not believe the European Central Bank’s (ECB) three-year loan facility represents a long-term solution to unsustainable levels of debt in Europe. With ten-year Italian yields still hovering around 7%, the bond market is skeptical of the ECB’s “back-door bazooka” as well. Since the December 19 low, stocks have turned a blind eye toward Italian yields. If the U.S. dollar ETF (UUP) can retake, and hold above, 22.62, it would add to our concerns about the sustainability of the recent push higher in stocks. Conversely, if UUP drops significantly below 22.62, it will increase the odds of stocks pushing higher over the next few weeks.

On Friday, Reuters reported there is no guarantee a disorderly default in Greece will be avoided. Below are some excerpts from the article No guarantee Greek debt swap will go through.

Asked if there was a risk of a disorderly Greek default, the senior troika official said: “Our objective is still to have a voluntary operation. If you ask me: is there a guarantee that there will be a voluntary operation? Of course there can never be a guarantee.”

“The ongoing discussions are constructive, they are useful, but at this point it is too early to say what will be the result,” the official, who declined to be named, told Reuters as the team of inspectors wrapped up a one-week visit to Athens.

Everyone is bearish on the euro, which means we need to respect the possibility of a rally. The weekly chart of the euro also tells us to be open to a bounce relatively soon. If the euro rebounds, it would be bullish for stocks and bearish for the U.S. dollar (in the short to intermediate-term).

Same situation with the ETF - FXE:

The S&P 500 held this week at 1,209, which is a Fibonacci retracement level based on the down move from the November highs. It is not unusual for markets to turn at Fib levels.

As we have mentioned on numerous occasions (see post), the door is still cracked for a possible push higher in stocks. It is not out of the realm of reason the S&P 500 could trade as high as 1,330ish in the coming weeks. Currently, there is little to support such a move, but given the divergences on the chart of the euro, we need to keep an open mind as events unfold.