Thousand-point intraday market moves, European debt crisis, wild currency moves, commodity prices collapse, volatility surges to new one-year highs. Whew! Are we having fun yet? We have been expecting a market correction and the correction has made a grand entrance. The NASDAQ composite, S&P 500 and small cap Russell 2000 index have already seen a 10% correction (or more) from their recent highs. The question is "will investors buy the dip this time or has the trend really changed?"
The main story driving this market remains the meltdown in Greece and its sovereign debt crisis. The problems with Greece's debt challenges have been discussed ad nauseam for weeks now. I do not want to bore you with repetition and will try and boil this down to the essence of the problem and why this is important.
It seems like every week the situation in Greece would come to a head as we moved into the weekend. EU leaders would scramble to meet and promise to hammer out a solution before Monday to "calm" the markets. Promises of support were pledged but money never changed hands. The "markets" never believed any of it and continued to send yields on Greek debt and credit default swaps soaring to new highs. The yield on a Greek 5-year bond recently hit 15%, which is a clear signal that investors consider them at high risk for default.
A week ago it seemed like the EU, the IMF and Greece had finally come to a real solution with a $140 billion aid package (which initially started out as a $61 billion aid package a few weeks prior). Unfortunately this new aid package would take weeks of red tape to actually get processed and Greece is facing an $11 billion debt payment on May 19th that they can't afford. In the mean time Germany, the EU's largest and strongest economy, has been balking at handing over cash to bailout Greece. Germany was not the only country in the EU that is reluctant to contribute their tax payer dollars to help Greece but Germany has been the most vocal. The idea of a Greece bailout is very unpopular with average Germans and German leadership was facing a tough election.
In just the last couple of days the German finance minister has convinced lawmakers to approve their portion of the Greece bailout suggesting that any other alternative would eventually cost the German people even more money and carry significantly more risk. While this is a positive step toward cooling market fears of a Greek default there are many who are still concerned that Greece will eventually end up taking the $140 billion aid money and end up defaulting anyway. The riots in Greece that have shutdown the country's transit systems and airports is a very loud and clear signal that the Greek people will not quietly accept these severe budget cuts required by the EU as a condition of the bailout. You know the other EU members are asking themselves if they will ever see this money again.
You may have heard the term before...that Greece is the "canary in the coal mine" for EU's sovereign debt challenges. It's not that Greece is so vital to the survival of the euro zone. In perspective it's relatively small. The worry is that if Greece doesn't survive and gets kicked out of the euro zone then the security of the euro currency is in doubt. Investors worry that it start a cascade of defaults across Europe that will eventually kill the euro and euro-zone. Currently Greece has about $236 billion in debt, which is about 120% of its GDP. They are running a deficit of 14% of their GDP. The combination of extremely high debt and huge cuts in spending is going to suffocate growth in Greece making it nearly impossible for them to pay back all of this debt.
Not only does Greece have to finance new debt to keep the country going but they have to find investors to buy their old debt as it matures (roll it over). Now who is going to buy billions of dollars of debt from a country on the verge of bankruptcy? The ECB recently stated they won't be buying any Greek bonds. This is the main reason the bailout will cost so much. Now apply this concept to the rest of the PIIGS countries. Portugal has been identified as the next country that could default and they have $286 billion in debt. The next weakest appears to be Spain with $1.1 trillion in debt and an economy struggling with 20% unemployment. Ireland has $867 billion in debt and Italy has $1.4 trillion (numbers come from the New York Times and the Bank for International Settlements).
The economic rebound in France and Germany, the EU's biggest members, has already stalled. If the EU rolls back over into a double-dip recession who is going to buy all of this debt that needs to get refinanced? It's not all due at once but you can see the scope of the problem. If the EU has struggled for
months coming up with a solution for Greece what are they going to do for Spain that is nearly four times the size of Greece? There have been examples of countries that managed to turn things around but it normally requires them to devalue their currency. The 16 nations in the euro zone cannot devalue their currency because they agreed to use the euro.
All of this uncertainty has wreaked havoc in the currency markets. The euro has fallen to new one-year lows against the dollar and the drop has been fast. Euro weakness has pushed the U.S. dollar higher by more than 6% in a week. If you don't trade currencies you don't realize what a monumental move that is. Currency trades are normally measured in pips or 0.0001 (1/100th) of a one percent. Thus a 6% move is huge. Most commodities are traded in dollars and this sudden dollar strength has yanked the carpet out from underneath the commodity market with oil futures down 13% and copper futures down 15% in a week's time. Gold is the exception. Normally gold moves opposite the dollar but all of this uncertainty and fear has investors pouring money into the safety of gold so gold has rallied. Investor fear has also pushed money into the apparent safety of the U.S. bond market and out of equities. Wall Street hates uncertainty. On Thursday when the S&P 500 broke down under what should have been key support near the 1150 level the selling escalated into an intraday market crash.
Chart of the U.S. dollar ETF (UUP):
Chart of the Euro currency ETF (FXE):
Thursday's market meltdown in the U.S. remains a mystery. The popular story blames an institutional trader in Proctor and Gamble who mistakenly hit the "b" button instead of "m" button so instead of entering an order to sell millions it was billions. There are plenty of skeptics regarding the "fat-finger" trade as the catalyst behind the meltdown but situations like that have happened before. Other's blame the high-frequency trading by computers. Program trading already accounts for the majority of our daily market volume. Industry experts claim these lightning-quick computers that trade in milliseconds offer greater market liquidity but ironically during the meltdown there was no liquidity. On several stocks the bids just vanished. There was no one there to buy at any price. I think Jim's OptionInvestor market wrap this weekend offers a very plausible explanation. When the market broke support there were probably millions of stop losses hit and triggers to go short that quickly escalated. It's possible that some highly leveraged hedge fund had to liquidate positions due to margin calls. All of it could have been exacerbated by the massive moves in commodities and currencies, which were being influenced by the Greece situation.
Having the market correct on us is not a problem. We've actually been expecting it. Unfortunately the system broke down for a few minutes and that creates more fear and uncertainty. Combine that with the uneasiness over Europe and anyone with big gains over the last year could be thinking it's time to take profits and get out. Complicating matters is the fact that capital gains are going to rise from current levels of 15% and income taxes are also poised to rise in 2011. I can certainly see the allure of taking profits now with the 15% capital gains rate and putting your money somewhere safer.
I have to admit that trying to plan long-term trades as we look out over the next six, nine, or twelve months is challenging. Readers already know that I have been worried about a double-dip recession hitting the U.S. in late 2010 or early 2011. Now it looks like Europe is going to slide into a double-dip recession a lot faster than expected. If the EU economies slow down and the euro continues to fall not only will their consumption of U.S. goods decline but the drop in the currency will make their exports more competitive with our own. Investors launching new bullish LEAPS positions will want to do so cautiously. I would consider scaling into positions a little bit at a time and only add to positions that appear to be showing strength. We can use the market correction as an entry point but you may want to look to buy the bounce instead of buying the actual dip.
That's enough bad news, let's talk about the good news. The jobs report on Friday was very strong. Sure, it's disappointing that the news failed to lift stocks but the results are encouraging. Economists were expecting the U.S. to see 185,000 new jobs. The Labor Department announced that April saw 290,000 new jobs. Now we've already been warned that spring and summer would see hundreds of thousands of new temporary census jobs created that could skew these numbers. The good news is that census workers only accounted for 66,000 of the April jobs gain. The private sector added about 230,000 new positions. What makes Friday's report even more bullish were the revisions for February and March. The Labor Department revised February from -14,000 to +39,000 and March was changed from +162,000 to +230,000. Altogether the economy just saw a boost of 411,000 new jobs (290K +121K in revisions). The unemployment rate did spike to 9.9% but that was due to a sudden increase in jobseekers trying to rejoin the workforce.
If you combine the jobs report with the previous week's positive data from the GDP, the PMI, retail sales, personal consumption, and consumer confidence numbers we are really starting to see some improvement. Bears will argue that all of this positive economic data was already baked into the market and they might be right but until we see the rate of improvement slow down the fundamentals in the economy should be positive for stocks.
I have been warning readers for weeks to expect a correction in the second half of April to early May. Now that the market has corrected what do we do? The S&P 500's drop from the 1220 area to the 1100 level is both a 10% correction and a test of round-number support near 1100 and technical support at its rising 200-dma. The NASDAQ has seen a 10% drop from its highs near 2530 and is testing support near 2200 and technical support at its rising 200-dma. The Russell 2000 index has produced a 12% correction and is testing support near the 650 level. Transports are off a little more than 10%. Semiconductors are down more than 13%. Banking indices are also off about 10%. While there has been a lot of damage in stock prices the larger trend off the 2009 lows is still up (for now). Last week I pointed out that the 1220 level on the S&P 500 was a major Fibonacci level of the bear-market decline and the market's bearish reversal under 1220 could be a signal that the rebound off the 2009 low is just a bull market inside a larger bear market cycle. If you subscribe to the larger bear-market philosophy then you may want to consider exiting bullish positions now or on the next oversold bounce (like maybe a bounce back to 1150 or 1180 on the S&P 500).
If you study the weekly charts most of the technicals appear to be rolling over into bearish sell signals from overbought levels. Yet on a short-term basis stocks look oversold and due for a bounce. What is a trader to do? I think active traders can use the recent weakness as an entry point but as I said earlier consider limiting your exposure with very small positions. Just because stocks are down 10% doesn't mean the profit taking is over and that the market will automatically rebound. The market tends to go to extremes. We were overbought for a while, we could move to more oversold levels. Obviously I'd like to see the S&P 500 hold the 1100 area. If we bounce here then great but even seeing the index consolidate sideways near 1100 would be okay. If the correction continues then we will probably see a decline toward the 1025-1,000 level on the S&P 500.
It has become a tired clichÃ© but the Chinese symbol for crisis is composed of two characters, one represents danger and the other opportunity. I feel like that's where the markets are at now. A 10% correction in an uptrend could be an opportunity to jump on board. It's also a warning to the danger that the trend could have changed. The challenge is how do we interpret recent moves? I am concerned that the velocity of the market's decline underscores a deeper lack of trust in the rally and probably the fate of the economic recovery. The 900+ point drop in the Dow Industrials on Thursday has scarred investor sentiment and brought back memories of the 1987 market crash.
Investor sentiment has definitely been damaged and it could take weeks before sentiment has healed again. Until it's healed the prevailing mood could be one of selling into strength. Unfortunately we remain hostage to the situation in Europe. EU leaders are meeting over the weekend yet again as they try to "defend" the euro from speculators. Of course the euro weakness is centered on the fiscal strength of Greece and the rest of the euro zone. If the EU can present a solid plan that assuages market fears then maybe stocks will rebound higher this week. Although given the track record of EU leadership I would be in the wait and see camp. Don't be surprised if the major indices retest the Thursday low before bouncing higher.
Chart of the S&P 500 Index:
Chart of the S&P 500 Index (WEEKLY):
Chart of the NASDAQ Composite Index:
Chart of the Russell 2000 Index:
LONGER TERM OUTLOOK
Previous Comments on my Long-Term Outlook:
My long-term outlook has not changed. I still expect the economy to see a double-dip, "W"-shaped rebound with the second dip in late 2010 (some analysts are predicting it will not show up until 2011). Lousy consumer spending, rising foreclosures, and lagging job growth will be the main culprits. Several weeks ago there were some comments out of the U.S. Treasury concerning foreclosures. The Obama administration's HAMP loan modification program can only help a certain number of homeowners and one official said that even if the HAMP program was a total success we should still expect millions of new foreclosures.
Estimates were in the 3 to 5 million foreclosures over the next three years but a White House advisor was quoted with estimates in the six to ten million range over the next three years. This only reinforces my own belief that we will see another tidal wave of foreclosed homes in 2010 and 2011. What is that going to do to consumer confidence and consumer spending? It's not going to help! You can review my long-term outlook here. It's the second half our my "Two Months Left" commentary.
~ James Brown