German Shift May Have QE-Like Impact On Stocks
To the casual observer, the announcements made late last week in Europe may appear to be just another in a series of "do the minimal to get by" moves by policymakers. In reality, Germany moved off their hard-line stance, which may mark a watershed moment for the financial markets, at least in the intermediate-term. Germany's shift may have a similar impact on the markets to the Fed's quantitative easing programs (QE) and the financial "TARP" thrown out during the 2008 crisis. A few similarities:
QE1 and QE2 did not "solve" the problems in the United States, but they did create conditions that were favorable for a protracted rally in risk assets. Economic health and financial markets can diverge significantly after new stimulative measures have been announced, meaning stocks can go up in a weak economic environment.
By attempting to drive up asset prices, QE assists overburdened balance sheets. TARP (Troubled Asset Relief Program) targeted the liability side of the ledger. Like QE and TARP, Europe's most recent moves target balance sheets. Stocks performed well immediately after QE was announced by the Fed and after TARP monies were disbursed.
As described in an October 2010 video, QE "stimulates" asset prices by injecting money into the global financial system. Unlike QE, bailout funds parked in a European bailout account are not stimulative or inflationary. The moves in Europe last week have unleashed bailout funds, creating a path for them to enter the financial system, which could have stimulative impacts similar to deficit spending, TARP, or QE. Details were in short supply in Europe last week, which means the stimulative impact could be delayed for quite some time.
Germany has made the bank recapitalization process easier, which in turn allows for troubled European banks to get balance sheet assistance. In 2009, when the financial markets realized banks were going to get bailouts, it marked a turning point relative to the trend in asset prices. The present day markets have countless moving parts, making forecasting difficult at best. However, the similarities between present day Europe and past stimulative/bailout programs are strong enough to warrant an open mind relative to better than expected market outcomes.
After a big rally, such as what occurred last Friday, markets often experience a "give back" in the following session. The concepts outlined here apply to the intermediate-term outlook. Even if the bullish scenario plays out in the coming weeks, we can expect numerous "scares" in the form of day-to-day volatility.
The video below summarizes the recent policy announcements in Europe and possible impact on asset prices. The latter portion of the video highlights several potentially bullish technical developments that have increased the probability of a multi-week or multi-month rally in stocks and commodities. Over twenty-five ETFs are covered in the video, including the S&P 500 (SPY), foreign stocks (EFA), Asia (AAXJ), emerging markets (EEM), commodities (DBC), gold (GLD), silver (SLV), mining stocks (XME), Treasuries (TLT), technology stocks (QQQ), and the VIX (VXX).
After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.
It is the subtle shift in Germany's approach that may act as the most bullish catalyst for asset prices. The European Central Bank and Fed have been calling for assistance from policymakers. The decision to have one euro-zone bank supervisor will be viewed positively by central bankers. Therefore, the Fed, ECB, and Bank of England may be more willing to expand stimulative policies, such as lowering interest rates, buying bonds, and reinstituting pure QE. From MarketWatch:
Traders expect the European Central Bank to also chip in by cutting rates next week to an all-time low. The Bank of England is also likely to ease monetary policy further by expanding its debt-purchase program. The European Central Bank, meeting on Thursday, will likely cut its benchmark rate to 0.75% from 1%, analysts at Citi and Credit Suisse forecast. The Bank of England's monetary policy committee also meets Thursday. Credit Suisse analysts expect the central bank to expand its current asset-purchase program by 75-billion pounds, although that may be split into two stages of £50 billion and £25 billion, they wrote in a note.
Despite the improvements in the technicals and the stimulative developments in Europe, our market models have not given the all-clear for the bulls. The concepts below were originally presented on June 21; updated values are included in the table below as of Friday's close. Despite the noisy look of the chart and table that follow, the concepts presented are easy to understand. Let's use the Relative Strength Index (RSI) as an example (last line in table). The chart below the table shows two intermediate peaks that occurred during the bottoms in 2010 and 2011 (points A and B in the chart). The table shows RSI hit 62 in 2010 and 65 in 2011 before stocks reversed and corrected significantly. RSI closed last Friday at 59, which is below both 62 and 65. The takeaway is as long as RSI remains below 65, then the odds of a significant pullback are meaningful. The odds of a significant pullback decrease if RSI exceeds 65. The same concepts can be applied to our market models. The table below has ten "all clear" thresholds for the current market to exceed. As of July 1, only four of the ten have been exceeded in a bullish manner. This tells us to take a measured and incremental approach to redeploying cash until more levels in the table are exceeded.
The chart below shows the periods in 2010 and 2011 when the S&P 500's 50-day moving average turned up in a bullish manner. Points A and A1 show the first tick up. The 50-day MA is shown in the top portion of the chart and the S&P 500 Index in the bottom portion. The S&P 500's performance to the left of points C and C3 show stocks experienced subsequent weakness (a correction) after A and A1 (where the 50 ticked up). The better entry points for investors came the second time the 50-day MA turned up (points B and B2). How does all this help us? If and when the 50-day moving average ticks up in a bullish manner, it tends to be indicative of a bottoming process, meaning we should be open to ongoing volatility, but also open to higher prices in the weeks that follow. It should be noted the S&P 500's current chart does not have a bullish, upward-sloping 50-day MA yet.
In the chart below of the Vanguard All-World Index Ex-U.S. (VEU), price is clearly above the upward-sloping trendline near point A. The 20-day moving average (blue line) held and turned up Friday in a bullish manner (see point B). Point C highlights a new higher high, which is indicative of an uptrend. The 200-day moving average (thin red line) is the next test for the bulls. The chart below was originally posted on June 15.
On May 7, we warned of slowing momentum in risk markets. Stocks followed with three weeks of falling prices. We shifted to a more open stance relative to a rally attempt on May 26, citing numerous weekly bullish divergences. A bottom tends to be more of a process than a one day event. On a day similar to Friday with eye-popping gains, it can be difficult to discern a climatic intermediate peak from the early stages of a prolonged move in asset prices. The weight of the evidence supports the bullish case. However, within the context of a bottoming process, stocks may need to backtrack one more time.
We began adding to our long positions on June 6. Since then, we have continued to incrementally add to the risk side of our portfolios as the markets showed improvement. We continued taking incremental steps via purchases last week.
We entered Friday's session with five core long positions and no short positions. We would have been more aggressive in terms of the percentages added Friday, but (a) the 60-minute charts were extended, and (b) some of the thresholds in the table above have not been exceeded yet. The market may need to make the bulls feel uneasy at some point next week. If stocks drop, given what we know today, we would consider adding to our positions. Once the market clears the hurdles in the table above, the incremental buys can occur in larger percentage increments (or on the next pullback). As long as the bullish trends continue, we will continue to favor Europe (EFA) over the United States (SPY) and remain open to adding to our recently acquired and small stake in commodities (DBC).