Stock market trend: Decisively
Broken
Market Pulse
Last week, I indicated that the market trend
was broken and that the best strategy for a risk-averse retail investor in the absence of a clear upward trend was a move
to cash. So emotionally, just how did you handle that observation when the stock market soared on the following
Monday?
If your reaction to that sucker’s rally was: “boy, I wish I’d been in the market and that Navarro
is an idiot” then you may not quite understand the underlying macro logic of a cash call in the absence of a definable
trend. At times like these, market participants have no clear consensus view on the future direction of
the economy. Some look at the robust leading economic indicators here in the U.S. and a (slightly) improving
job market and are bullish. Others look at the Eurozone debacle and see a collapse of the global economic
recovery and are bearish.
At such times, “playing the market” is like playing roulette. It’s
a 50-50 gamble (less your trading costs) rather than an intelligent speculation. In such circumstances,
you may well experience the “high” of winning for a day such as we had last Monday. BUT you
are just as likely to get hammered – as the market was in the last two trading days of the week.
The broader point here is to get your emotions out of your trading.
If the market has an up day in times such as this when there is no clear market trend, don’t regret sitting on
the sidelines. When the market has several down days, don’t even gloat that you were out of
the market. Just wait and watch for the trend to reestablish itself and then implement whatever stock-picking
strategy you have found to be best.
The Euro is Dead
Now let’s switch gears and talk about where the trend is likely to go
– up or down – and what the falling euro means:
1. The euro is
likely to continue in a long term decline
2. The euro will continue to decline because “Le Tarpe” will either lead to a massive boost
in the euro money supply OR a collapse of the euro if countries that want to borrow “Le Tarpe” funds refuse to
agree to the conditions of accepting the money. There is NO third option so the euro must fall!
3. A falling euro will hurt the U.S. economy directly by reducing U.S. exports to Europe. But this
is a small effect since European exports only account for about 2% of the U.S. GDP
4. A falling euro will indirectly
hurt the U.S. economy by reducing the probability that China will revalue its yuan relative to the dollar. This
is the far greater impact because it will mean continued trade deficits with China here in the U.S.
5. China won’t
revalue the yuan at this time because as the dollar is rising, so, too, is the yuan. This hurts Chinese
exports to Europe – its largest market. Ergo, there is no way China would allow further strengthening
of the yuan to the euro by strengthening the yuan relative to the dollar!!! (If you don’t understand
this one, please re-read until you do. It is the single most important dynamic right now in the global
recovery besides the euro collapse itself.)
6. The decline in the euro boosts gold and silver prices by raising the probability that gold and silver
will be de facto “reserve currencies” in a world where high sovereign debt levels in both the U.S. and Europe
make the dollar and euro less attractive as reserve currencies over time.
7. The usual positive correlation
between gold vs. oil and commodity prices has been decisively broken by the euro crisis. A stronger dollar
drives down oil and commodity prices BUT a weaker euro boosts gold as a reserve currency play.
8. It is easier
to paint a bearish global scenario from the euro collapse than a bullish one. The bearish scenario is this:
Europe stagnates as “Le Tarpe” fails because of political pressures that were not present in the U.S., i.e., while
the U.S. could make demands on Citi and AIG et al, the Eurozone bigwigs can’t bend Greece and Portugal and Spain to
their will. China implodes on a combination of collapsing real estate and stock market bubbles coupled
with a fall in exports to the Europe. The U.S. continues to be leached by Chinese mercantilism while it
loses its export growth in Europe while internally states like California and Illinois undertake contractionary measures that
ripple across the nation.
Of course, despite this colossal bummer scenario I have presented, the global economy may still recover
and the bullish market trend may soon resume. But to come full circle, why would you want to be fully invested
on the long side at this particular point in time? Unless, of course, you prefer emotional gambling to
intelligent speculation.
I leave you with this observation from Market Edge about the technical condition of the market:
The
technical condition of the market stayed in a weakened state last week as the CTI and the Momentum Index remained in bearish
territory while the Strength Indexes collapsed. Following the nasty sell-off which occurred the week ending
05/07/10, it came as no surprise to see the market bounce last week. What was somewhat of a shocker was the size of the rebound
which saw the DJIA gain 3.9% and the NASDAQ 4.8% on Monday alone. Despite the fact that both the DJIA and the NASDAQ finished
the week with a gain, the technical picture continues to point to rough sledding over the next several weeks. … With
the negatives far outweighing the positives, the probabilities are high that the correction has a way to go. Typically, sharp
declines are followed by a series of failed rally attempts over a 3-4 week period with a valid test of the previous lows needed
before a genuine rally can develop. Monday's bounce was a good example of such a bounce.
In my last newsletter several weeks ago, I noted
a continued bullish trend. However, I also said that:
“Despite the market's bullish trend, I continue to be
cashed out of most of the stock market and have shifted a significant chunk of my assets into a new piece of real estate.”
My personal
cash call, which went against the grain of the market from a technical perspective, was made on the basis of pure fundamentals.
That, in fact, is often the flaw with technical analysis. It misses key market turning points.
Whether this is a turning
point and the start of a downward trend or, as many of the talking heads have tried to portray it, simply a 10% market correction
remains to be seen. However, the "this is only a market correction" chatter is extremely dangerous. It assumes that
the market will simply go down 10 or 15% and then you will have a green light to go back in. Ergo, in this view, with you
should be doing now is buying on the dips and accumulating bargains.
From a retail investor’s point of view, this
is just plain stupid. The reason this is stupid is that none of these talking heads talking correction have any clue as to
why this market is going down. They view the recent dip as a technical correction rather than something more fundamentally
wrong.
From a retail investor's point of view, the best thing to do -- and the only thing to do -- right now is to stay
out of the market until the trend reestablishes itself. In this regard, I did a very interesting segment last Friday on CNBC
that talked about the different incentives facing retail investors versus institutional investors -- and what is implied by
those different incentives.
Small retail investors -- and I include people with up to several million dollars in the market -- have
the great advantage of being nimble and flexible around market turning points. There's absolutely no reason not to make a
move the cash because liquidation of one's complete portfolio can have no impact on market prices. Moreover, small retail
investors are not required by any covenants to be committed to the market.
In contrast, consider an institutional investor
like a mutual fund. A large, high-growth mutual fund may have extremely large positions in stocks like Intel or Apple or Cisco.
If that fund tries to liquidate all of the shares in any of those stocks in a single day, the large liquidation will likely
weigh heavily on the price and cost that mutual fund some profit points as he tries to exit. At the same time, many mutual
fund managers must cope with the forced requirement of having his or her fund mostly in stock positions rather than on the
sidelines in cash.
You should see immediately now from these observations why it is never in the best interests of an institutional
fund manager to come television as a commentator and recommend that people sell their stocks. (In the worst-case scenario,
you may well have a talking head telling people to buy on the dips and grab great bargains even as that very same fund manager
is liquidating positions in those stocks, essentially selling on the rallies he or she helped fuel with "buy on the dips”
commentary.)
So to reiterate: if you are a small retail investor, use your flexibility to stay on the sidelines when the market
trend is indeterminate or in a downward bearish direction. And be very wary of any advice you hear about "buying on the
dips" or going bargain-hunting when the trend is down or undefined.
As for the market trend, here is what I think
is going on from a macro point of view. With the yield curve flattening and with the stock market trend broken, the financial
markets are casting some significant doubt on the strength of the global economic recovery.
The best way to think about the global economy
is as a three-legged stool consisting of Asia, Europe, and the Americas. Right now, and this may seem surprising, the Americas
may be the strongest leg of the stool.
Particularly in the United States, we seem to be in the midst of a reasonably
good recovery -- although GDP growth rates at this stage of recovery are far below historical norms. Asia, too, has been doing
relatively well. That said, there are growing doubts about the Chinese economy, which is coping with significant bubbles in
both the stock market and real estate market -- but China at least continues to appear to be booming.
That leaves Europe. The
message here is that the real story in the headlines is not about the "Greek debt crisis" but rather about the death
of the euro as a reserve currency -- and the likely stagnant economic growth in Europe that may follow for some years.
Right now,
the euro zone has 16 countries that have adopted the euro. My prediction is that there will never be a single additional
country that will join the euro zone. This is because the recent Greek debt crisis has exposed the folly of any country
surrendering both its fiscal and monetary policy in order to join the euro.
The biggest part of that folly is Germany. German
sensibilities about fiscal and monetary policy are totally out of tune with the rest of the European continent. In a nutshell,
the Germans prefer austerity and export led growth to a reasonable level of consumption and a more balanced economy. Hence,
as much of the rest of Europe has gone stagnant -- and wrecked their balance sheets in the process -- Germany runs a huge
trade surplus and a relatively small budget deficit. Of course, its leaders want everybody else in Europe to do the same thing
-- but the German model only works because of its "beggar thy neighbor” export strategies. So it is all a nonstarter
-- and a huge recipe for continued conflict. Memo to the world: there are really good reasons why it has always been Germany
that starts world wars in Europe. The Germans are different from everybody else -- and have a low tolerance for the rest of
Europe to conform to the German will.
On the euro question, it's not just that no additional countries will be joining the euro zone anytime
soon. It's also that some of the countries in the euro zone must eventually leave under the weight of their weak economies
and large budget deficits.
In fact, at least some, or perhaps all of the so-called "Piigs” -- Portugal, Italy, Ireland,
Greece, and Spain -- will find that the only way for them to restore economic growth will not be through the austerity measures
crammed down their throat by the Germans and the IMF. Rather, it will be through currency devaluations that make their exports
relatively more competitive. However, such competitive devaluations cannot happen until a country exits the euro and regains
its sovereign control over its currency and monetary policy.
So here's the bottom line: no more countries joining the euro and
some countries eventually leaving. Because the financial markets understand that the euro is effectively
dead as a reserve currency, it is placing its bets accordingly. Hence, the dramatic fall in the value of the euro against
the dollar.
The biggest picture here is that the euro zone faces turmoil for years to come. Much of this turmoil will come from
the internal contradictions spawned by the German conundrum. A likely result will be a rate of economic growth lower than
it would otherwise be. However, if the European leg of the stool is weak, there will likely be not enough support for global
economic recovery over time.
As to why we specifically care about whether Europe is weak -- and whether the euro is weak -- it's
all about global trade. A weak Europe buys fewer Asian exports and fewer exports from the Americas. In this way, the two other
legs of the stool are hurt.
So to answer the question posed by the title of this newsletter -- what just happened -- it wasn't about
a fat finger computer glitch. It was about the recognition by financial markets that something is rotten in Denmark -- and
the rest of Europe.
So let me reiterate my bottom line: this is not the time to be buying stocks. Watch the markets carefully
and get your buying list ready. But don't jump in with both feet until the trend is reestablished.
