Worries over a Greek debt default and the impact that would have on the European banking system have the stock market locked in a state of fear. The S&P 500 index is down five out of the last six sessions and it's down six out of the last seven weeks. Last Monday may have been a holiday for U.S. markets but the sell-off in Europe continued. European markets are trading at two-year lows and European banking stocks are getting crushed with many of them down -35% to -40% in the last two months. Money continues to flow into safe haven securities like the U.S. ten-year bond and the 10-year German bund.
The rally in the bond market and the spike in the volatility index (VIX) are clear signs that investors are worried. They would rather park money in the 10-year note yielding less than 2% than risk it in the equities market. Less than eight weeks ago the 10-year U.S. note was yielding about 3.0%. Today the yield is close to 1.9% and hit 1.89% at its lows on Friday. That is a monumental move and reminds me of the massive rally in bonds back in late 2008 during the Lehman Brothers market meltdown. Yields have broken down under their 2008 lows to hit new 60-year lows.
Weekly chart of the 10-year bond Yield:
The volatility index (VIX) remains elevated above the 30 level and saw a +12% spike on Friday. Yet thankfully we are nowhere near the levels seen back in late 2008. There is always the chance that the "fear gauge" rallies to multi-year highs if we do see a debt default in Europe.
Long-term chart of the Volatility Index (VIX):
Some of the biggest moves last week were in currencies. Rising concerns over trouble in Europe sent the euro currency plunging. This fueled a big rally in the U.S. dollar, which kept pressure on commodities. Most commodities are traded in dollars so a stronger dollar usually means cheaper commodities. This helped keep a lid on gold. Otherwise we probably would have seen gold surge to a new high.
Weekly chart of the Euro ETF:
Weekly chart of the Dollar ETF:
Looking back, last week was all about Europe but we'll hit some of the non-Europe highlights first. In the U.S. the August ISM report came in better than expected at 53.3. Economists were expecting a drop from 52.7 to 51.0.
There were some concerns midweek that China and Japan might face a debt rating downgrade. Meanwhile, Federal Reserve Chairman Ben Bernanke briefly made headlines when he spoke at the Minnesota Economic club but his comments offered nothing new and mainly repeated his Jackson Hole statements.
I warned readers a week ago that we would likely see fireworks out of Europe. Sure enough the Greece/Italy/Germany/EU soap opera did not disappoint. Germany is Europe's largest and strongest economy and the lynchpin to any further EU aid for its struggling neighbors. Thus it was big news when a German court struck down a lawsuit challenging that country's participation any EU bailouts. This news helped fuel market gains on Wednesday. Unfortunately the market reversed on Thursday. Market participants were surprised that the European Central Bank left interest rates unchanged at 1.5%. With so many EU economies bordering on a new recession the market was expecting further help from the ECB. Reinforcing this atmosphere was the ECB's downward revision to their EU GDP forecast.
Friday's stock market decline was also fueled by a number of stories. The biggest was rumors that Greece could announce a default over the weekend. Thus no one wanted to be long the stock market, especially financials. There was also news that a German official had resigned from the board of the ECB and that Germany was working on a backup plan to strengthen their major banks should Greece default.
There has been talk before about how the major EU countries should stop funding bailouts and instead use their cash to strengthen their own banks so that when a default occurs their own economies don't crash too. Thus it was a one-two punch to hear that Germany was working on an emergency plan to underpin their banks on the same Friday that Greece was rumored to default. I'm surprised the stock market did not see sharper declines.
The problem is not just Greece. They are a tiny country in the scheme of things. The challenge is what might happen if they are allowed to default. How many tens of billions of dollars in Greek debt is owned by all the European banks? How many banks would fail if Greece defaults? Furthermore, if Greece throws up their hands in defeat and says, "We can't pay back all this money, sorry." What will stop Ireland, Italy, Portugal and Spain from doing the same thing?
Greece is already facing depression levels of economic growth because of all the austerity measures. No one wants to live through that. It's tough to be a politician when your country is suffering a depression. Do you really thing these politicians have the will power to do the right thing or take the easy road? I'm sure the political pressure on the PIIGS countries has been intense but how long can it last? If a Greek default could cripple the entire European banking system, what would a default by Italy or Spain do to the banking system? The prior European bank "stress tests" have been considered a sham because they never truly accounted for a default. You can see why authorities and the markets are so concerned about the "contagion" effect or "domino" effect. If Greece falls, who's the next country to default?
Last week's trading action in the U.S. markets is worrisome. Not only has the S&P 500 index formed a bear-flag pattern (we mentioned this last week) but it has also formed a bearish head-and-shoulders pattern over the last there weeks. Depending on where you draw the H&S pattern and the neckline, a breakdown would forecast a drop toward the 1,050 level. Yet a breakdown from the bear-flag pattern would forecast a drop toward the 1,000 level. Considering these ominous technical signals you can see why I'm reluctant to add a bunch of new bullish long-term LEAPS trades.
Short-term the S&P 500 index has support near 1140, 1120 and then the 1100 level. Overhead we are looking at resistance near 1200 and 1230.
FYI: a drop under 1090 would mark a new bear market (-20%) for the S&P500 index.
H&S pattern on the S&P 500 index:
Bear Flag pattern on the S&P 500 index:
Weekly chart of the S&P 500 index:
It's not quite as clear on the NASDAQ but it too appears to be building a bear-flag pattern. Plus, it also has the three-week bearish head-and-shoulders pattern. The H&S pattern would forecast a drop toward the 2200 area. While the flag pattern would forecast a drop toward the 2100 area.
Daily chart of the NASDAQ Composite index:
Intraday chart of the NASDAQ Composite index:
Naturally it is the same story on the small cap Russell 2000 index. The bear-flag pattern, if confirmed, would forecast a drop toward the 550 area. The three-week bearish head-and-shoulders pattern would forecast a drop toward the 550 area. To get there it would take the $RUT to breakdown under the longer-term trendline of higher lows on its weekly chart (essentially a breakdown under the August lows).
Daily chart of the Russell 2000 ETF (IWM)
Intraday chart of the Russell 2000 ETF (IWM)
I will admit that the combination of multiple bearish technical patterns is pretty ominous. Yet these patterns are not fool-proof. There is no guarantee that the market will breakdown or hit these potential downside targets. We can use them as a warning signal that the market is weak and the path of least resistance is probably down. If you're comfortable playing the bearish side of things then they offer clear entry and exit points, which would be easy to do using options on the SPY, the DIA, the QQQ, and the IWM.
Next week the focus will remain on the drama in Europe. Yet here at home we will see some key economic reports. The key reports to watch are the PPI on Wednesday and the CPI, Empire manufacturing index, and Philly Fed on Thursday.
- Tuesday, September 13 -
- Wednesday, September 14 -
PPI for August
Retail sales of August
- Thursday, September 15 -
Weekly Initial Jobless Claims
CPI for August
New York Empire Manufacturing survey for September
Philly Fed survey
- Friday, September 16 -
University of Michigan (Consumer) Sentiment
Stocks look weak. The crisis in Europe is getting worse. The S&P 500 index could be facing another -10% drop over the next several weeks. Personally, I would consider adjusting your stop losses or scaling back current positions to reduce risk. There is a chance that Ben Bernanke pulls some sort of rabbit out of his hat at the meeting two weeks from now. Yet whatever stimulus the Fed provides it may not trump a credit default in Europe.
You could definitely argue that a Greek default is already priced into the market but that does not mean that stocks would not see a massive knee-jerk reaction on the news. Aggressive and nimble traders may want to consider trading short-term put options on a breakdown and target a drop toward 1050 or 1000 on the S&P 500 (make sure you buy options with enough time to get there). Technically a breakdown under 1090 would be a new bear market for the U.S. market but a decline to 1050 or 1000 is probably an entry point for us a longer-term option traders.
I still think the market could bounce from another test of the 1120 or 1100 levels on the S&P 500. If we see a close under 1100 then we definitely need to switch gears and put our crash helmets on.
Don't forget that the end of October is fiscal year end for a lot of money managers. Who knows where they will buy the dip? If the market does rally off support we could definitely see fund managers chasing the rebound.