Taking Shelter - Part II
"Europe is the world's largest economy, and there won't be global economic recovery without European economic recovery...We hope Europe will be fine". ~ Hu Jintao, Chinese President - FT
As the news from the European front comes in a deluge of contradictions and imperatives, I am reminded of those dog days of 2007 when we first caught a trailer of what was coming to theaters in 2008. At that time America was ground zero of the financial crisis - we just didn't know it or realize how significant its effects would be to our economy and the global landscape in general. Certainly there would be hardships for those that lived beyond their means, but the effects to the broad majority would be tolerable - was the conventional thinking at that time. Our housing boom and leverage buyout bonanza had inflated expectations across the capital spectrum and impaired judgments from the consumer to the captains of industry. I am reminded of the now infamous quote from Chuck Prince, then CEO of Citigroup, in July of 2007, several months after the subprime crisis rattled the ABX market - igniting the financial crisis and sealing the markets fate.
"The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.
He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back.
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance, We're still dancing" he said in an interview with the FT in Japan" ~ Time July 10, 2007
I am amazed on a daily basis at how quickly we forget, or recklessly ignore, the same script now repeating itself with different actors, with all of the same character flaws and expectations. Just yesterday I was reading a headline that ran, "Gabelli: Greece has about as much impact as Maryland"
"Mario Gabelli says that he doesn't expect the U.S. economy to enter a recession again, but "the data says that if it does happen, it will be shallow one." "The fundamentals of keeping the economy in reasonably good shape are there, so the rest of it comes down to psychology," said Gabelli, the founder of the Gabelli Funds." ~ Marketwatch
And while I agree with Mr. Gabelli that the data to date indicates a domestic economy in "reasonably good shape", looking slightly past the end of our noses, we can see real risks on the horizon, due to the inevitable recession now sweeping Europe.
This is not quantum physics folks - extrapolating the glide-path at this point is basic logic.
I would argue that since the core of Europe is just starting to see data representative of an actual recession, such as the large decline in factory orders out of Germany Friday, or the contracting PMI's across the eurozone last week - it would be foolish to look at the current data without acknowledging what will inevitably be influencing the global economy in the months to come. Like Chinese President Hu Jintao acknowledged, Europe IS the world's largest economy, and to boot it's also China's biggest trade partner. To think our markets will somehow get off scot-free is truly hoping for it's a "different this time" scenario. While it is true that recession fears have abated in the U.S data series recently, a majority of the weak data was likely attributed to the spike in energy and commodity prices in early spring and the severe impact of the Japanese earthquake this past winter. I would argue, the real fireworks have yet to be seen from the European crisis in our markets - no less the effects upstream in China. While transparency has been in short supply as to where we stand in Europe, market participants have had a volley of catalysts, hopes and instigators to choose from in miscalculating what has truly been wagging the dog.
Considering what we now know of the austerity measures being debated and implemented across the eurozone, I would argue it is much clearer now, then it was in 2007, to extrapolate the significant risks to the financial markets going forward. In 2007, austerity measures, while topically appealing in principal - would have greatly magnified the broader risks to the economy and lengthened the recovery. I realize that may seem shocking, considering what we now know of the tepid recovery, but this was certainly not your grandfather's depression, domestically speaking. An unfortunate reality is there will likely be some countries in Europe that will now face that very real possibility.
The good news for investors is that the market has provided ample opportunity to exit as it has traversed a very broad and complex range. Generally speaking, the broader and longer a market takes to complete a top, the greater the downside risks become. And while that very process has succeeded in confusing the majority of participants - going forward the path of least resistance will likely become more stubborn towards the downside.
What I can logically infer from the technical soundings and various market relationships I monitor, is that although our own markets are the deepest and most attractive at the Ugly Betty pageant this year, the relative strength of the U.S dollar will maintain pressures on the equity and commodity markets over the coming months. As mentioned throughout the year in my notes, I believe the US dollar is poised to begin a secular bull market that will have kinetic consequences in the short to intermediate timeframes. Eventually, the strong inverse correlation of the dollar and the equity markets will weaken, but it will certainly not materialize overnight. It was my hope in the beginning of the year that the destabilizing dynamics of a stronger dollar would have marginal consequences towards our markets, but considering we now know the catalyst of the dollar's pivot to be the very severe structural issues that are now coming to a head in Europe - that seems increasingly unlikely. Certainly the Fed could attempt to balance the equation and slow the euro's descent with additional rounds of quantitative easing, but they are boxed in by where the dollar sits in its technical range and the politics that have infiltrated even the Fed itself. The ECB on the other hand, with its new and feisty president - have a far more overvalued currency (see Here) to accommodate quantitative monetary measures.
I believe it is highly likely that we will experience an environment, similar to November of 2008, where the ECB and the Fed is actively attempting to stimulate - but its effects are relatively impotent at rekindling risk appetites in the face of real fear. They are in essence pushing on the proverbial string. I believe we have seen the first indications of this in markets such as silver, where only last year the first hint of QE2 sent the white metal on a screaming trajectory to 30 year highs. Furthermore, if you were to look at the oil market, you can see the stubborn contrast in how hedge funds have maintained their bullish biases in the face of a structurally changed and downtrending market. Both of these observations lead me to believe that the secular run in commodity prices has ended with the secular bear market in the dollar.
So in this scenario, where would Ms. Market turn - or has she already?
My best guesstimate is the window opened last week and could extend to the end of November. As mentioned in my previous note (see Here), I am following the financials quite closely - specifically the parallels to late 2007. For color I am also monitoring the RSI's of various markets for a convincing break of 50 - as it has indicated a trend reversal in the past. I have included below two charts contrasting the similarities in the bond markets non-confirmation of the October rally in equities. While it is never a given that the bond market is the smart money barometer of risk - the alarming divergence between the two markets should give equity traders pause as they consider the prospect of new highs a realistic target for years end.
I will leave you with a quote from a man I indirectly (my Grandfather was also named Albert Schweitzer) derive my middle name from and whom I am a descendant of. It is a message of consciousness we so desperately are in short supply of, and one I feel will become ever more absent in the continuing hardships.
"Just as the wave cannot exist for itself, but is ever a part of the heaving surface of the ocean, so must I never live my life for itself, but always in the experience which is going on around me." ~ Albert Schweitzer