Monday, January 16, 2012

Market Thoughts Week of Jan 16

With a lot of issues to discuss, this will be a slightly longer post.

To decouple, or not to decouple? That is NOT the question.
Simply put, EU-27 is the largest economy on the planet and is one of our largest trading partners. S&P 500, mostly through U.S. multinationals, gets more than 20% of its earnings from Europe. It is widely known that Eurozone is heading into recession. This will reduce S&P 500 earnings through multinationals. Further weight will be put on those companies' profits by higher dollar (through weaker euro).
Many U.S. banks have operations in Europe. If defaults occur (Greece comes to mind), there is going be a contagion across the entire financial system. Jamie Dimon (JPM's CEO) just disclosed that his bank has $15B exposure to PIIGS and could lose $5B of that. Europe accounted for 50% of total U.S. global foreign direct investment in 2010.
How can these facts be decoupled from U.S.? This decoupling talk is ludicrous!

S&P EU sovereign credit downgrades finally came.
Friday the 13th and MLK long weekend was the worst time to do this. But equity markets handled it fairly well. One just can't be too bearish equities when you see a respectable strength like this. Be careful and chose your entries wisely (on this a little later).
The most important downgrade for me was Italy. With two-notch downgrade it is now just three notches above junk. Can you say Greek debt multiplied by 5.5? Once Italy's credit rating is junk, it will be shut out of the bond market. ESM and EFSF together would not save Italy from default then.
So who will S&P downgrade next? My guess is another deeply indebted country in EU. Perhaps Mr. Baroin (French Fin Min) gave S&P their next downgrade idea, when he asked in dismay why UK's rating is still AAA?

Will UK decouple from EU too? Oh wait, it is in EU. Long-forgotten is Mr. Cameron's stance on abstaining from new "fiscal compact". Check out GBP chart, it is not looking too good lately.

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A warning shot?
On Thu we got some weak U.S. Econodata. Dec retail sales disappointed. I warned about this right after Thanksgiving, as XRT was not able to take out early Nov highs even with best Black Friday sales ever. I drove around every weekend after Thanksgiving, and my local mall traffic was down ever since. Combine this with last week's less than expected Non-Mfg ISM, and you have a weaker consumer. I am worried now!
Weekly jobless claims shot up. Are we to be surprised? Temp workers are being let go in droves, as holiday shopping season is over. We will have to see if the trend develops. Also, (very quietly) Philly Fed was revised down to 6.8 from 10.3 last week. Hmmm, nobody noticed? We get Jan # on Thu of this week, watch it...

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Doves are flying high.
Late last year economy picked up growth. If we are to believe that good economic data will continue (despite my doubts in the previous paragraph), no QE should be needed this year. 2012 GDP growth is projected at around 2 - 3% by economists. So why are the majority of Fed members pounding the table for QE3? Simple answer - our economic recovery is too fragile and can not be sustained without Fed's help. Let's not kid ourselves, training wheels came off at the end of QE1 and QE2, and we know what happened shortly after in both instances. So QE Light was put in place, and now QE3 may follow. Market fully anticipates this. 10 Yr T-Note futures just made new high, and much higher levels are still ahead, accompanied by record low yields. Whatever Fed's reasons are - high unemployment rate or slow housing recovery - they may hint about QE3 at their 2-day meeting in January (as they just whispered into CNBC's ear). By the way, I think that QE3 is not that bad of an idea, especially if directed at RMBS: equities will like it, bonds will like it, and more importantly - Fed will reflate the stagnant housing market. Housing stocks have gotten the message early in Oct. I believe that was about the time Fed started speaking about QE3 (via RMBS purchases) - I guess bear market plunge in S&P 500 did the trick.

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But is housing really bottoming?
US govt is looking into wholesale disposal of FHA, Fannie, and Freddie-owned homes. Investors (mostly hedge funds and alike) will be buying these in bulk and renting them out. I have one major question - at what price? What do you think will be the bulk rate paid by those vultures? Can you imagine what it will do to comps in the neighborhoods where transactions will take place? Are we going to have another huge decline in prices due to that brilliant scheme? I say look for 25-30% discounts below CMV on those bulk transactions. Until now GSEs have been selling their properties on the avg of 5-7% below CMV to owner-occupants and small investors.
Home owners, who will see their equity evaporate and go into negative column on 25-30% hit due to comp sales in their neighborhood through this new program, will default on their mortgages in an instant. I am still yet to hear anyone explain how this vicious circle gets avoided. Until then, I will think that housing bottom is false and is about to drop out.

Technicals are flashing some possible changes ahead.
SPX is up against 1295 resistance again. Daily MACD is now negatively diverging from price. Daily Stoch is still embedded in buy, but once it crosses down below 80, we may have a bigger pullback than the one we saw on Fri. It is in rising wedge formation, a bearish reversal pattern. I wonder what may make traders pull the sell trigger: earnings, Europe, or just overly bullish sentiment, which is now flying high. We had a good run from Oct lows, pullback will not kill the trend.

VIX may help this possible bearish case. Divergence on daily inside of the falling wedge has developed and needs to be monitored. Higher volatility levels may be ahead.

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