What if Cyprus defaulted and withdrew from the eurozone and nobody noticed?

Market Statistics

A week ago the world economy was spiraling down the rabbit hole because Cyprus was contemplating a 10% Stability Tax on bank deposits. Cypriot banks were closed for two days. The euro was dead and the eurozone was falling apart. Markets around the globe were selling off because a country with the GDP smaller than Vermont was considering the unthinkable.

Fast forward a week and the Cypriot banks are still closed until next Tuesday at the earliest. The two largest banks with large portfolios of bad loans may be closed permanently and depositors with more than 100,000 euros could see their accounts frozen for months or possibly years and receive up to a 40% haircut courtesy of the EU and government of Cyprus. The U.S. markets closed within a few points of new highs and the Dow added +90 points. Nobody seems to care what happens in Cyprus. What a difference a week makes.

The Cypriot problems disrupting the markets early last week were overblown given the size of the country and its immediate impact on the global stage. The big fear was the potential for bank runs across the eurozone and those that did materialize were small and contained. Apparently eurozone depositors correctly thought "What happens in Cyprus stays in Cyprus." They may think differently once the eventual solution is announced next week but for now Cyprus is just a headline buried on page two of the local newspapers.

For the U.S. market the conventional wisdom would have been to sell stocks before the weekend to avoid any unpleasant surprises from the Cypriot solution on Monday. Apparently conventional wisdom was tossed out the door and the Teflon market saw investors buying the dip ahead of quarter end.

There were no economic reports of note on Friday. The Mass Layoffs for February rose from 1,328 events to 1,422 but the number of workers impacted only rose slightly from 135,026 to 135,468. Since the data is a month old and there was no material change the report was ignored.

The SEMI Book-to-Bill ratio for February declined only -0.01 to 1.10 from 1.11. It was hardly an earth shaking move. That was the second consecutive month in positive territory over 1.0 and the first time since Q3-2010 that has happened. The semiconductor industry has been in the dumps with orders falling below shipments for two years and this suggests a rebound in the making. Thank you Apple and Samsung.

The economic calendar for next week has some important events. The Richmond Fed Manufacturing Survey on Tuesday will be important after the Philly Fed Survey returned to positive territory last week. We need to see confirmation from the Richmond and Kansas surveys.

Bernanke will give a speech on Monetary Policy at 1:15 PM on Tuesday. That is always dangerous but coming so soon after his press conference last Wednesday I am not expecting any fireworks.

The Q4 GDP revision on Thursday is expected to rise from the microscopic +0.13% growth in the last revision to +0.3% growth. I can hear the oohs and aahs from the cheering crowd as you read about that stellar growth upgrade. Almost nobody expects a positive surprise and there are a few looking for a return to negative territory. The report we need to worry about is the one for Q1 after the impact of the fiscal cliff and the sequestration. That report will not appear until April 26th so the market has plenty of time to form expectations. Currently they are for growth of +0.13% in Q1. I am not holding my breath.

The ISM Chicago, formerly Chicago PMI, due out on Thursday is expected to decline despite the strong manufacturing activity in the auto sector. The Kansas Fed Manufacturing Survey is already in negative contraction territory and it could decline even more when it is reported on Thursday.

Economic Calendar

We are approaching a critical point in the economy and the economic reports in April are going to be critical. The tax hikes from the fiscal cliff in December are now fully implemented and individuals and businesses have had time to adjust their spending habits. The impact of the sequestration will have begun and we should see a decline in spending all across the economy.

The impacts of Obamacare are starting to be reported almost daily in the business news. This weekend is the third anniversary of the law's passage. Employers are cutting full and part time workers back to 29 hours a week so they won't have to pay for health care. Small businesses are cutting back to fewer than 50 total employees for the same reason. The businesses that can't cut back are raising prices to offset the higher expenses. Subway, Red Lobster, Burger King along with hundreds of other companies have already announced they are raising the price of their products to compensate for the added expenses.

A new update last week revealed a new $63 per worker surtax that was hidden in the 15,000 pages of regulations. In explaining the fee the administration said, "The fee is intended to help millions of Americans purchase affordable health insurance, reduce unreimbursed usage of hospital and other medical facilities by the uninsured and thereby lower medical expenses and premiums for all."

The United Auto Workers Medical Trust covers 806,000 workers and the trust is asking for an exemption. So is Boeing with 405,000 employees. Boeing said that fee alone will add $25 million in costs. Health and Human Services denied the request by Boeing and said "some" of the autoworkers could be exempt. So far the HHS has issued waivers for unions representing 543,812 workers. Why do they get special treatment?

The Associated Press reported this week that insurance companies are warning existing customers to expect premium hikes of +20% to +100% in January 2014. "If you like your plan you can keep your plan" if you can afford it. Also, if your annual plan payments are more than $10,200 you can be considered to be in a "premium" program and be subject to the "Cadillac Tax" starting January 1st.

As we get closer to the full implementation of the healthcare system you can bet there are going to be dozens of unexpected fees and price hikes. You can't add 40 million currently uninsured people into the healthcare system without the rates for everyone else going up accordingly. This is going to be a major drag on the U.S. economy and once into the third quarter the daily news stories are going to weigh on the market.

You may have seen the news stories on Homeland Security ordering 1.6 billion rounds of ammo, 7,000 machine guns and 2,700 armored personnel carriers for delivery later this year. At the height of the Iraq war the military was only using 5.5 million rounds a month and there were 500,000 soldiers. Those 1.6 billion rounds would fuel a war of that size for 30 years. They recently put out an "emergency order" for riot gear, body armor and "bullet proof checkpoint booths." What are they preparing to defend? Why are all the orders being placed on an "emergency" basis? Could it be they are expecting riots after the Affordable Care Act goes into effect in January?

The FAA announced on Friday it was closing 149 air traffic control towers on April 7th due to forced spending cuts in the sequestration bill that went into effect on March 1st. The FAA said it has to cut $600 million from its budget for the rest of the year as a result of sequestration. Multiply this for every government agency and there will be an impact to the economy.

In stock news BlackBerry (BBRY) fell -8% as the Z10 phone went on sale in the USA. The new touch screen BlackBerry went on sale with less than an enthusiastic response. In an AT&T store in midtown Manhattan only about 24 had been sold by late afternoon. There were no lines at any store according to technology reporters.

The Z10 phone costs $200 at AT&T with a two-year contract. Some analysts suggested most hard core BlackBerry users were waiting for the Q10 model with a real keyboard. That model is expected to be out in about two months. Unfortunately that will put it in direct competition with the new Apple phones. Today's -8% decline was a textbook buy the rumor, sell the news event.

BlackBerry financed special training for Best Buy employees from 1,400 stores so there would be a resident BlackBerry expert in every store.

BlackBerry Chart

Apple (AAPL) shares had a good week with a close over $460 after bottoming at $420 in early March. Rumors making the rounds late in the week had a June 29th announcement event by Apple. The announcement was expected to be an iPhone 5s, a new iPad and possibly the leaked iWatch. Rumors of a Samsung watch and even a Google watch are also making the rounds so Apple could announce it just to beat the crowd. Even LG is rumored to be working on a Smartwatch. LG is also working on a product similar to Google Glasses. The tech consumer will have plenty to choose from in 2014. Throw in a potential dividend upgrade by Apple and the stock is finally moving higher.

Apple Chart

AK Steel (AKS) issued guidance for Q1 and shipments are expected to be down -8% from Q4. Prices were expected to be slightly higher and would limit the loss. They are expecting a loss of 9-13 cents compared to street estimates for a loss of 9 cents.

Steel Dynamics (STLD) issued guidance earlier in the week that was flat to lower on earnings. The company said shipments to be "considerably flat sequentially" due to a wide range of problems. The company said increased shipping volumes would be offset by decreased margins.

Both companies echoed analyst comments over the last couple weeks claiming steel demand was lower and prices were falling. UBS warned that iron ore prices could return to crisis lows, a -54% decline from the current level. UBS blamed China's sluggish economy for the slowing demand. When coupled with rising ore volumes from miners the price will decline. Seaborne supplies could climb 9% in 2013. UBS said prices could decline to $70 a ton after trading between $130-$160 through June. Goldman said seaborne supply will outpace demand by 20 million tons in 2013, up from a 37 million ton shortfall in 2012.

AKS shares declined to a ten-year low.

AKS Chart

It was not a good week for earnings but the market ignored the bad news. Caterpillar (CAT) warned that sales for the three-month period ended in February declined -13% compared to the year ago period. Sales fell -26% in the Asia/Pacific region, -12% in North America, -9% in Europe, Africa and the Middle East. The big declines in Asia/Pacific (China) are particularly troubling. Caterpillar is typically considered a proxy for the global economy.

CAT Chart

Federal Express (FDX) reported earnings that disappointed despite rising volumes. The overall shipping volume rose +4% but shippers are electing to ship by ground methods rather than by air. Shippers are focused on price rather than speed and that suggests a downturn in global economy. Operating margins declined to 1.8%, down from 5.3%. FedEx expected the declining international trend to continue. The company is going to ground more planes that deliver to Asia and retire older planes. Like Caterpillar, FedEx is typically considered a proxy for the global economy.

FedEx Chart

Oracle (ORCL) reported earnings that disappointed with declines in license revenue and hardware sales. License revenue for new software and subscriptions fell -2% to $2.3 billion. Slower than expected hardware sales were blamed as more corporations move to the cloud instead of buying expensive hardware that requires ongoing maintenance. Oracle said hardware sales would plunge as much as 23% in the current quarter.

Oracle Chart

Not all earnings were bad. Nike (NKE) beat the street for an unexpected surprise. Earnings of 73 cents beat estimates of 67 cents. GAAP earnings were 95 cents and rose +58% over the comparison quarter. Revenues rose +9%. Sales in North America rose +18% and gross margin improved for the first time in ten quarters. Nike shares rallied +11%.

Nike Chart

Tiffany (TIF) posted earnings of $1.40 compared to estimates of $1.36. Revenue rose +4% to $1.24 billion. Sales in the Americas rose +2% but same store sales declined -2%. Sales in New York declined -3%. Sales in Asia-Pacific rose +13% while sales in Japan declined -6%. European sales rose +3%. It is clear that China was the growth driver here and the U.S. barely posted any gains. Tiffany warned that Q1 earnings will decline between 15-20% due to pricing pressures and higher marketing costs. Tiffany shares rallied +2% but the earnings warning will probably drag on performance in the weeks ahead.

Tiffany Chart

Darden Restaurants (DRI) posted earnings of $1.02 that beat the street by a penny on a +5% increase in revenue. However, same store sales declined -4.6%. Darden operates the Olive Garden, Red Lobster and LongHorn Steakhouse restaurants. With taxes higher in 2013 and gasoline prices at their recent highs the retail experience, especially in high end casual dining is going to be under pressure. McDonalds and lower priced fast food restaurants should do better.

Earnings expectations for Q1 are horrible. S&P is expecting earnings growth of +0.58%. With a couple more warnings like we saw last week and that estimate is going to be negative. The outlook for future quarters is bordering on fantasy. Earnings in Q2 are expected to grow +7%, Q3 +10.1% and Q4 +15.6%. Given the comments from Oracle, FedEx, Caterpillar, Tiffany, etc the earnings for the rest of the year are not going to be anywhere close to those estimates. The market seems oblivious. In just the last week we have seen earnings estimate downgrades on ARG, CSCO, JDSU, GES in addition to those companies listed above that missed earnings estimates.

One factor specifically is going to make it difficult for companies to hit estimates in Q1. That is the sharp rise in the dollar. The dollar index rallied to six month highs in March and the euro plunged an equal amount. Oracle, Caterpillar and Tiffany already used the dollar as a supplemental excuse in their poor earnings.

The dollar is due to decline as a result of QE but it will take a decent decline to really help out on earnings for companies doing business overseas and that is about 80% of the S&P-500. The euro is falling because the eurozone is in a recession. The PMI was negative for the major countries in the releases last week. Until Europe begins to recover the dollar will remain strong. Once the reversal in both currencies begins it could be a wild ride.

Dollar Index Chart

More than 88% of the S&P-500 stocks are trading over their 200-day average. Typically any number over 80% becomes problematic and investors begin to back off their bullish positions. That has not happened yet.

S&P Stocks over the 200 Day Average

Markets are being powered by the fear of missing opportunity more than the fear of losing money. However, cash balances at funds are at two-year lows at roughly 3.8%. That is very close to fully invested since they have to retain some cash for liquidity and withdrawals. Merrill Lynch said global fund managers hold a 53% underweight exposure to the bond market. That is the lowest since April 2011. More than 57% of managers were overweight equities compared to a 4% underweight in June 2012. Fund managers currently hold an 11% underweight exposure to commodities. That is the lowest since the June 2012 bottom. The Merrill survey showed expectations for further gains in the dollar were at record highs.

Despite the volatility over the past week the market outlook has not changed. We saw some ugly earnings from notable companies and the market failed to implode. We have seen the previously unthinkable occur in Cyprus where individuals may lose up to 40% of their cash on deposit and the market blinked and then ignored it.

The fear of missing out on the next move is overpowering the fear of a correction. This mindset should continue through the end of next week. Fund managers are chasing performance and trying to make up for either being late to the rally or shorting it outright throughout the quarter.

The Dow and S&P are likely to make new highs. That would be the perfect way to end the quarter with everyone fully invested and then start setting up to get out if earnings disappoint. After last week I don't expect too many upside surprises but anything is possible.

Assuming the earnings cycle does not surprise to the upside I expect the "sell in May" cycle this year to be especially painful. Investors can't look to the global economy for optimism because there isn't any. I doubt they can look to the U.S. economy for improvement because of the forced spending cuts and layoffs. Even if we continued to grow at +1% GDP it is not enough to increase hiring to the point where the economy gains traction.

There are too many headwinds in the months ahead. Until we see some real growth and some real improvement in hiring the future earnings estimates are going to continue to fade as we approach those quarters.

Eventually the Fed is going to lighten up on the QE and the market is going to react badly. A lot of analysts are expecting a change in Q3 but the economy would have to take a sudden turn higher for that to happen.

Those points above mean we are just passing time while we wait for a sign the global economy is improving. The U.S. can't really decouple from the world economy but it can be the strongest ship in a rough sea.

The S&P closed at 1,556 and about -9 points from the historic high at 1,565. Support at 1,540 held on multiple attempts and barring some unforeseen headlines we should creep higher on end of quarter window dressing. We are still in danger of a triple top correction but probably not this week.

S&P Chart - Daily

S&P Chart - Monthly

The Dow missed posting a gain for the week by -2 points. The close at 14,512 was -27 points below the historic closing high at 14,539 on March 14th. The Dow has gone sideways for seven-days as we pass time until quarter end. The support at 14,400 was tested on three days and each time there was a corresponding rebound.

The increased volatility is symptomatic of a market top and volume has been weak. Friday's total volume of 5.3 billion shares was the lowest since February 11th. Daily new highs at an average of 400 for last week are less than half of the rate from two weeks ago. The high for new highs was 1,022 on March 14th.

The Dow will probably make a new high next week. If we were to get some triple digit explosion to a new high I would be looking for weakness to short.

The trend is our friend until it ends and a big new high would attract sellers like a moth to a flame.

Dow Chart

The Nasdaq is less bullish than the S&P and Dow. The index did test support at 3200 but has settled into the middle of the prior range. The Nasdaq is still at the mercy of Apple and Google and fortunately Apple is starting to show promise. I am concerned the Nasdaq will simply run in place next week and not put in a serious breakout effort. If the Nasdaq was to move higher there is strong resistance around 3275. The semiconductors are also holding the Nasdaq back. The SOX is well off its highs.

I would not use the Nasdaq as my index of choice for long plays next week. Be selective and pick a tech stock rather than the QQQs or another ETF.

Nasdaq Chart

The Russell 2000 Index was the biggest loser last week. It was not much of a loss at -0.6% but it matters. We need to watch the Russell and the Transports for signs of a rally failure. Those are the two indexes that matter the most. The Russell tested support at 938 on Tuesday and then resistance at 950 on Wednesday. Both held and the index faded into the Friday close. That support at 938 is critical. I would short a breakdown below that level using the IWM.

Russell 2000 Chart

The Dow Transports tested support at 6100 on Thursday and rebounded +1% on Friday. That sounds good but the chart says otherwise. The Transports closed nearer to support than the other indexes. We could very easily see a retracement of the Friday gains and a break below 6100. Short the Transports using the IYT ETF if 6100 support fails.

Dow Transport Chart

As of Saturday afternoon Reuters is reporting the EU and Cypriot leaders have tentatively agreed to impose a 20% to 25% levy on accounts over 100,000 euros at the Bank of Cyprus and a 4% levy on accounts of that size at other banks. This is not final and it is not over until it is over. The second largest bank, Cyprus Popular Bank, may also fall under the 20% rule. The country has to come up with 5.8 billion euros in order to qualify for a 10 billion loan from the Troika.

The Cypriot banking system had 68 billion in deposits when the banks were closed a week ago. They are now scheduled to reopen on Tuesday. There was 38 billion euros in accounts of 100,000 euros or more. With only 1.1 million people in Cyprus that is a huge amount of money and illustrates how much money is in the system from offshore accounts. More than 20 billion is thought to be owned by Russian citizens. Cyprus got into trouble by using all this offshore money to buy Greek bonds. The banks paid a big yield because Greek bonds were high yield. When Greece imploded and the bond debt was forcibly restructured it left a gaping hole on the bank balance sheets. The principal on Greek bonds was cut by as much as 80% and the repayment terms extended for years. Now the banks can't cover the deposits.

This is one of those European situations where there is no easy answer. If the Troika refuses to give Cyprus the 10 billion loan they will be bankrupt and the banks will not be able to open without ECB support. The ECB has already said it will not support the banks unless the government gets the loan. Even then the two largest banks may have to be closed and a "bad bank" created to hold all the bad loans. Depositors could be forced to wait years to get their money back after the assets of the bad bank are sold.

The options for Cyprus are few. Suck it up and make the hard decision, tax the deposits and accept the loan or see the banks fail and be forced to withdraw from the eurozone. Cyprus is agonizing over the deposit taxation plan but it is a mute point. If they don't tax the deposits the banks can't reopen and depositors get no money back for a long time, if ever. The country is already in a crisis because cash has evaporated and businesses are shutting down. ATM lines are long and painful.

ATM Lines

If this was any other eurozone country it would be a disaster. Cyprus has a GDP of $23 billion, which is smaller than Vermont and the damage will be localized. The U.S. markets have already written the country off as nothing but a bump in the road and assumed as in all past eurozone problems that a solution will be found or the can kicked farther down the road. If the country decides to commit euro suicide and leave the eurozone it could weigh on the markets because of the unknowns related to dropping out of the euro. They would have to print their own money (pound or lira) and exchange it for the euros on deposit. You can imagine the disaster that would become in determining an exchange rate for the new lira.

The Cypriot banking system is heavily connected to Greece. A collapse in Cyprus would require emergency loans to Greek banks. Greece is already seeing depositors withdraw money on fears the Cyprus contagion could sink the Greek banks or cause a new round of deposit taxes in Greece.

Russian banks have more than 40 billion euros of loans outstanding to Cyprus based companies. If the Cypriot banking system failed or they dropped out of the euro those loans would be in serious jeopardy. That could be a 2% hit to Russian GDP.

Everything is connected to everything else. This is why there has to be a solution and Cyprus can't be allowed to fail. This is why the market ignored the problem on Friday. Cyprus can't be allowed to fail or the entire European debt crisis explodes back into the headlines. Expect an ugly solution but at least a solution. Once the banks reopen they are going to be immediately hit with massive deposit flight out of the country. This means Cyprus may have to implement some form of capital controls even though it is prohibited under eurozone rules other than under "exceptional circumstances."

Numerous analysts believe we will look back at the Cyprus tax as the pivotal event that ended the eurozone. Peter Schiff wrote that EU leaders, primarily Germany and France, were so politically arrogant, reckless, economically ignorant and emotionally callous as to violate the sanctity of bank deposits in order to fund a bailout of Cyprus. The decision was almost universally described as a historic blunder.

The next problem to rear its head is deposit taxes across the eurozone. Spain announced last week it is considering a tax on all bank deposits. If Spain is seeing the deposit tax as a way to share the pain then other countries are going to follow suit. If countries suddenly wake up to the potential to raise instant money by taxing deposits the genie will be out of the bottle and the taxes never ending. JP Morgan believes this is imminent and it will further expose the fragmentation of the European banking system and its inconsistency with a monetary union.

The chief economist of the German Commerzbank has already suggested a 15% financial asset tax on all Italians as a way to reduce the debt to less than 100% of GDP. More than 29% of Italian businesses are failing because the banks have no money or no will to lend. Pass a 15% tax and 50% of businesses will fail. Without a doubt depositors in Spain, Italy, Greece and Portugal are going to believe their funds are at risk and there will be a continued cash drain on the banks.

The markets are likely to move higher because of quarter end window dressing. That assumes the headline flow remains neutral and Cyprus is resolved.

The House and Senate both passed the continuing resolution budget bill to keep the government funded through the end of September so the March 27th budget deadline is no longer valid.

Enter passively and exit aggressively!

Jim Brown

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