The markets got a preview of what we can expect on Friday when headlines from Europe showed an increasingly fractured coalition and slim chance of a grand plan emerging on Friday.
The grand plan is slowly fraying at the edges. Nearly every headline out of Europe this morning outlined a different component of the rumored resolution that was deviating from expectations. The first crack in the anticipated plan came from the head of the ECB, Mario Draghi, when he said the bank would NOT be buying a large amount of bonds and it would NOT be lending money to the IMF so the IMF could loan it to needy countries. Draghi said lending to the IMF for that purpose would be illegal according to the current rules.
Last week the ECB head made comments suggesting the ECB could be ready to come to the rescue with a large and aggressive buying program if the top six credits in the euro zone were to agree to a new fiscal pact. It was also rumored the ECB could be ready to loan from 250 to 350 billion euros to the IMF so they could loan it to Italy, Spain and other needy countries. Neither rumor is true according to Draghi. He also said he was surprised to see the market misunderstood his earlier comments regarding aggressive bond buying. The markets always expect the best. Expectations are like yeast to the market.
The ECB did cut interest rates by 25 basis points to 1.0% and they announced three year loans for EU banks. They lowered the rules on the collateral they would accept for those loans. They also lowered the collateral they would require for holding sovereign debt. In any normal week those would be big moves for the ECB but they were ignored today.
While on the subject of the EU banks the EU Banking Regulator said today the banks need to raise an additional 115 billion euros in capital. That is larger than the 106 billion in the last estimate in October.
The grand plan being discussed over the last couple of weeks suggested the stronger countries wanted a fiscal pact with teeth where budgets would be approved by the European Commission. That appeared to falter on Thursday as multiple countries objected to unelected bureaucrats in another country telling everyone how they could spend their money. We knew this was not going to fly. I have said so many times. Why it would come as a shock to the market is confusing. It is that hopium drug again.
The fiscal pact portion of the EU summit may eventually happen but it will be a very long process. The chances it would happen in some form at this 15th EU summit on the debt crisis were slim to begin with and they went downhill from there. Sarkozy reiterated the need to change the taxation rules on euro zone countries and change the labor laws as part of the fiscal process. Don't hold your breath there. Merkel changed her tone from "we must get something done this week" to "the current discussions are just one step in a very long process." While the EU leaders are open to looking at some changes to the treaty the first drafts of the new language have now been targeted for March. Once the final draft is complete it could take up to two years to get all EU countries to approve it. That assumes they will approve it and I have serious doubts that many countries will cede budget power to the EU commission.
Another buildup of expectations suggested the European Financial Stability Fund (EFSF) and the new European Stability Mechanism (ESM) would operate simultaneously. The ESM will have 500 billion euros to use for bailouts. That fund was supposed to start in 2013 but they said today it would be moved forward to July 2012. Unfortunately Germany rejected the idea of operating both side by side and that plan went down in flames. That means the EFSF will end in July when the ESM begins. It also cuts nearly in half the available funds at that time.
They are talking about a change to the new ESM fund to allow action with only 85% of the members voting for approval to spend the money. This is fallout from Finland holding up the Greek bailout and wanting collateral for their loans. I am assuming they will need 100% to approve the new rules to act on an 85% vote in the future. Will that 100% vote pass since the dissenters will be essentially losing their vote in future matters?
Lastly Germany vetoed the idea of making the ESM a bank so they could borrow from the ECB. That further cripples the future capabilities of the ESM.
The euro zone is a monetary union not a fiscal union. That means countries like Greece can spend ten times the money of other countries and still benefit from the common currency. There is no risk their overspending and massive debt will tank their currency since they are essentially using the common currency to mask their spending. That was the past. Sarkozy and Merkel are now lobbying for a balanced budget clause in the new fiscal pact that would limit budget deficits to 3% of GDP and carry automatic penalties for failure to stick to that budget. If your welfare state always spends more than that and you know that is not likely to change then why would you vote to penalize yourself and impose limits you can never reach?
The hope for a sixth comprehensive plan to come out of the 15th EU debt summit was misplaced. The market reaction today is likely a preview of coming attractions. At this point I don't see any possibility of a grand plan being announced on Friday. Just before the market closed there was a leaked draft of the EU post meeting announcement. There was little in the way of material changes and definitely some serious disagreements. The market plunged to the lows of the day as the details were made public. This was a "leaked draft" so anything can change on Friday but it would take a major shift in positions and the addition of multiple new talking points before the market will get excited again.
Sarkozy said late today, "If we don't have a material agreement by tomorrow, we are out of time" meaning they would be unable to avoid a further significant worsening of the crisis.
The next challenge is the S&P downgrades. They warned they could downgrade 15 euro zone countries, the EFSF, the EU in general and the entire European banking system if a material agreement was not reached. It appears there is no real agreement and certainly nothing material in the form S&P was expecting. How long will it take S&P to follow through on their threats?
U.S. banks were crushed today as traders shorted every financial institution in sight. They have banned shorting of financial institutions in Europe so the only way to protect yourself against declines in Europe is to short U.S. banks. JPM fell -5%, Citi -7% and Morgan Stanley -8%.
In the U.S. there was some good economic news that spiked the futures before the open. The weekly jobless claims dropped sharply to 381,000 and the lowest level since February. Last week's 402,000 number was revised only slightly higher to 404,000. These numbers do have seasonal adjustments to account for the holidays and hiring patterns so they can be volatile. I would not put too much faith in a -23,000 decline in claims in one week. However, even if the number is revised higher next week it should still be well under 400,000 and a step in the right direction.
Jobless Claims Chart
Wholesale trade for October rose a whopping +1.6% compared to estimates of +0.3% and a decline of -0.1% in the prior month. Sales rose +0.9% compared to +0.3% in the prior month. Durable goods inventories rose +0.8% and nondurable goods rose +2.8%. Inventories rose in nine out of ten categories. The rise in inventories should be a strong support for Q3 GDP gains.
Moody's Inventory Chart
The economic calendar for Friday only has a couple reports but they will be ignored because of the EU summit meeting in progress.
Stock news was mostly ignored because the EU summit and the grilling of Corzine monopolized the headlines. Jon Corzine was interrogated by Congress about the missing $1.2 billion at MF Global. He did not take the Fifth Amendment and tried to answer the questions asked without getting into too much trouble. Since he was a former senator he knew the drill. Talk slowly, admit nothing, claim no knowledge and be polite.
When asked repeatedly if he authorized anyone to use customer segregated funds for company purposes he said he did not "intend" to give anyone instructions that would have put customer money at risk. "Intent" is a key word. Without intent to commit wrong it is hard to prosecute for the wrongdoing. It ends up being a series of unfortunate events. He was asked to describe a scenario where someone may have misunderstood his instructions. He said it was possible he told underlings to "fix it, we have to fix it" on the night he found out the company was insolvent. Obviously, this will eventually boil down to a "he said, they said" argument in court on who may have done what and when. That will be months down the road. Corzine did say repeatedly he expected the money to be found. He said I was as shocked as you when I heard the money was missing. Time will tell if that was a true statement.
There could be as many as 10,000 accounts still frozen or worse investors holding insufficient checks for their withdrawals. Investors began to close accounts and flee MF Global several days before the company filed bankruptcy. If your account was still open then your funds were supposedly safe and would be returned to you in the bankruptcy process. If you closed your account in advance and received a check for the balance and that check bounced as thousands have then you have a claim in the bankruptcy for your unpaid check. While the two claims may sound the same the resolution may be entirely different.
A NSF check is just a debt while segregated funds are not a part of the bankruptcy at least in theory. Obviously lawyers will argue that the checks were segregated funds as well but it is one more layer of legal standing that must be proved. Lastly MF must have funds to distribute. If they really comingled funds and those funds are gone then that presents another complication to the bankruptcy court. You could end up the "victim" of a fraud and only receive a portion of recovered funds. Those whose checks actually cleared could be forced to return a portion of those funds to compensate victims who received nothing. This is not a pretty picture and it has seriously impacted trading in the commodities markets. The most logical scenario is that MF was hit by major margin calls in the final days as the company imploded and funds were moved among accounts to cover those margin calls.
Tesla Motors (TSLA) was downgraded by Morgan Stanley to underweight from overweight and the price target slashed -37% or -$26 to $44. TSLA shares fell -10% to $31 on the downgrade. MS analyst Adam Jonas said although there was increased interest in electric vehicles they were not yet ready for prime time and would be slow to catch on with drivers. Tesla only sells one car, the Roadster, for $109,000. The Model S, four door sedan, is expected to be launched this summer. Jonas said that would allow Tesla to ramp up revenue over the following year but sales would be slower than investors expect. He said the market for electric vehicles would likely be only 4-5% of the total market through 2025. That was down from his prior prediction of 8.6%. He cut his estimates because of improvements in gasoline engine technology, disappointing sales of electric cars in general and the prospects for a weak European economy.
Texas Instruments (TXN) warned after the close the weak global economy had cut demand for its chips. The company said it saw "broadly lower demand across a wide range of markets, customers and products" except for wireless application processors used in smartphones and tablets. In Q4 the company said it now expects to earn 21-25 cents compared to an earlier forecast of 28-36 cents. Analysts were expecting 35-cents. TXN shares were hit hard after the close but the warning came so late there was little time for traders to react. I would expect further declines on Friday.
Texas Instruments Chart
The S&P rallied this week exactly to strong resistance at the 200-day average at 1265. After four days of bumping against that strong resistance while we waited for the political theater to play out in Europe, traders finally gave up hope and the S&P declined -26 points today.
In the end there was simply not enough conviction there would be a successful resolution in Europe to push the markets higher. Without a stunning change of events overnight I would expect traders to lose interest and I worry the normal December rally is in jeopardy.
I have said several times I was skeptical the EU leaders could pull a rabbit out of their collective hat and actually come up with a solution. There is too much disagreement because there are marked differences in governments and societies in each of the euro zone countries. We have seen this movie before with 15 debt crisis summits and five comprehensive solutions and we are not much closer to a solution than we have been in the past.
I believe the potential for further gains over 1265 in the near future is going to be slim. I could be totally wrong and anything is possible but we need to be aware of the possibility of a decline and it could be a steep decline. The flurry of warnings like we saw from Texas Instruments tonight are a sign the global economy is slowing. Shipments from Asia to Europe are down -20%. Europe is falling into an austerity recession. China has posted troubling declines in manufacturing and services activity. The U.S. is the only major growth area today and our pace is at crawl speed. I think these factors will become more of a drag on the markets now that Europe has failed a critical test.
The S&P closed at 1234 but there is no real support until those same levels we struggled with on the way up at 1225, 1200, 1185, 1160. I would certainly hope we don't have to retest those lows but what is the market going to use for hopium in the days ahead?
Strangely the S&P futures are up +4 points tonight.
The Dow declined to 12,000 at the close and what is seen as round number support. A break there should be an express elevator ride back to 11,600. The financials are a major component of the Dow and they will not likely recover if Europe fails to produce a credible plan. The energy stocks are also a major component and without a plan European oil demand would be expected to decline. Tech stocks are a major component and the warning from Texas Instruments should weigh on them on Friday.
I would be very surprised to see a material rebound from here.
The Nasdaq closed down -53 points even though Apple was positive on some iPhone sales news. The Nasdaq closed under 2600 and the warning by TXN after the close should weigh heavily on tech stocks on Friday. I fear we are going lower unless something changes quickly. Support is 2600 so the open will be a key indicator.
In case I have not made myself clear in past commentaries. I viewed the European outcome as questionable at best and remained skeptical the market would move higher after the announcement. I recommend only small positions and tight stops if traders had to be in the market. Those fears appear to be coming true and once past Friday we need to find something else to focus on for market sentiment.
The next milestone to pass is the FOMC meeting on Tuesday. With the improvement in U.S. economics they might not want to change policy with an eye towards further easing. However, if the market implodes on another failed EU summit they may try to head off a new bear market by announcing some new program. At least that is what the market will be hoping for after Friday.
Trade the trend and take profits early.
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