Last week was the worst Thanksgiving week percentage decline since 1932. That is quite a change from nearly six week highs the prior week.
News from Europe continued to weigh on our markets and the Dow gave up triple digit gains at Friday's open to end the day down 26 points. The list of negative headlines seemed endless but was led by record bond yields on Italian debt of more than 7.8%. That rate was for 2.6 billion euros of zero-coupon bonds and it was up from 4.6% in the prior sale. Eight billion in 6-month bonds drew a record 6.5% yield, nearly double the 3.53% in the prior auction. The two year BTP bonds were over 8% despite ECB buying in the secondary market. Italy is planning to sell another eight billion next week and conditions are not improving.
Italy has to sell 440 billion euros in new bonds to cover expiring debt in 2012, with over 200 billion by April. They currently owe more than 1.9 trillion euros. Analysts claim there is more than 150 billion in debt that will be redeemed in the first quarter with no intention of buying additional debt. That means firms that would normally replace expiring debt with purchases of new debt have indicated they will not be buyers when their current debt matures. This suggests Italy may lose its access to the bond markets if this lack of interest trend continues. If that happens the interest rates demanded by investors will either be so high Italy can't afford to issue the bonds or the bond sales will fail and leave Italy with no way to redeem maturing debt.
Germany, the strongest country in the 17 nation common currency eurogroup, tried to sell six billion euros in debt last week and only succeeded in selling 3.6 billion. If Germany can't sell debt at a decent price then Italy and Spain are out of luck. Spain sold debt at 5.2% yield earlier in the week thanks to their new austerity committed conservative government. It was a high rate but at least the auction was successful.
Headlines out of Greece spooked the market on Friday after the news broke that existing Greek debt could end up with a 75% haircut instead of the previously agreed 50% cut. Apparently conversations with the banking group facing the 50% haircut turned negative after it was proposed they would get 15% in cash and 35% in new debt. The problem was the discount rate on the new debt. Banks claimed the present value of the yield they were being offered reduced the value of the deal to a 75% haircut. As part of the prior deal ALL bank holders of the old debt had to agree to the voluntary exchange for new debt in order to keep the credit default swaps from being triggered. Apparently the value of the new deal being discussed caused many of those banks to kick it back as not acceptable. November was the second anniversary of the Greek debt problem and I doubt it is going away.
I am sure many investors are confused as to why the holders of Greek debt are so willing to take a 50% haircut rather than execute their credit default swaps and bail for 100% payment in full. The way I understand the problem the majority of the Greek debt is held by European banks. They do not have to reserve capital for sovereign debt they hold so they can hold a lot of it with no capital cost. Banks that own Greek debt may have taken out credit default swaps with other European banks. That means a bank that does not own any Greek debt outright could have substantial exposure if it wrote default swaps on debt held by others.
Since most European banks deal in a closed environment with other European banks there could be a lot of cross collateralization between banks with this debt. If everyone hedged their debt holdings with others in the euro then everyone is liable for the debt in some form. If the holders of Greek debt were downgraded after a default then those banks writing the hedges would also be downgraded. Many banks have bank debt held by other banks. If those banks were downgraded then that debt would be downgraded and so begins a long chain of falling dominos as each interdependency weakens another bank.
That non-sovereign debt does have a capital cost and a wholesale downgrade of European bank debt would mean a massive recapitalization would be needed by the entire European banking system. This is why nobody can afford to execute the credit default swap provisions. Obviously it has to be really bad when banks are willing to take a voluntary 50% haircut to avoid triggering the swaps. They are more afraid of the ramifications of pulling the trigger on their credit default swaps than losing billions in a "voluntary" debt exchange. That should give us a clue as to how serious the interdependency problem is and why this problem is not going away soon.
If you are listening to the headlines you know there has been a lot of talk in recent days about countries leaving the euro and a core group of countries possibly creating a super euro coalition. In order to join their coalition a country would have to agree to oversight by a governing committee able to enforce fiscal rules and subject the country to legal penalties through the World Court if the country failed to abide by the rules. Basically they would give up their fiscal sovereignty as a condition of joining the super coalition. While that sounds good on paper it will never fly because no country with a weak socialist welfare state is going to turn financial governance over to a group led by Germany. No welfare state is going to allow the EU commission to control government payments to its citizens.
It is almost a sure bet that the eurozone we have today will not exist in its present form in 2015. The eurozone got into trouble because it was so easy to borrow money under the cover of the common currency and rules on limitations of debt. Five years ago Greece could borrow money at basically the same interest rate as Germany. Unfortunately there turned out to be no real enforcement of those rules and as we are finding out there is no common responsibility for the debt incurred. The economic model is broken and the only way to fix it is to evict those unable to follow the rules.
On Friday Belgium, a founding member of the European Union, was downgraded by S&P one notch to AA. There were multiple reasons for the downgrade from the failure to form a new government, the inability to cut spending as demanded by the EU and weakening banks that may require a government bailout. Analysts saw this as additional evidence the EU is crumbling in stature as well as credibility. S&P said Belgium's debt to GDP was 93% and could soon top 100%. There is a strong likelihood Belgium will require financial support from the EU. The benchmark 10-year bond rose to 5.83% yield on Friday from 4.17% earlier in the week. There is a Belgium bond auction slated for Monday and odds are very good it will not go well.
On Thursday Fitch cut Portugal's debt rating to junk at BB+. Moody's had already cut them to junk in July and S&P has them just above that level but will probably follow suit soon. Portugal's 10-year bond yields rose to 13.85% and the second highest in the eurozone behind Greece. Moody's downgraded Hungarian debt to junk status (Ba1) as well. Hungary is not a member of the EU but does trade with EU countries currently under stress.
European stocks sold off last week after Germany's Chancellor Angela Merkel dismissed calls for the ECB to take a bigger role in halting the debt crisis. Merkel repeated her opposition to the use of eurobonds issued by the European Commission. Germany opposes the bonds because they are the strongest country and could end up shouldering a large portion of the risk if other countries failed to live up to their commitments. It would also cause German bond rates to rise. A ZDF television poll conducted last week of1,276 Germans showed 79% were opposed to eurobonds. Only 15% supported the idea.
Where do we go from here? It would seem the European debt crisis is far from over and will get materially worse before it gets better. Asking European leaders to act quickly and take financial responsibility for problems in other countries is an impossible task. German citizens don't want to pay for Greeks and Italians on permanent welfare. A part time work week, long vacations and dozens of other social welfare programs are not acceptable to industrious Germans. The ECB is the only entity with the power to stop the contagion. The ECB, like the Fed, can print money and buy bonds to keep rates low. However, Germany is strongly opposed to further bond buying for reasons I listed above. Until Germany relents the ECB is limited to the amount of firepower it can use. Last week the ECB only bought $6 billion in bonds, down from $12.7 billion in the prior week. Germany is preventing a full fledged rescue even though the contagion spread to its own bonds last week. Like I said earlier the economic model is broken and not likely to survive.
That means the U.S. markets are going to have to put up with worsening conditions overseas for the rest of 2011 and probably 2012. Eventually the U.S. markets will disconnect from the declining conditions overseas but we can't disconnect from the impact of European austerity. Consumption is going to decline in Europe. China has already warned of a dramatic decline in orders from Europe. Maersk Line, the world's largest container shipper, said it was cutting capacity to Europe. Orient Overseas said it was cutting capacity between Europe and Asia by 20%. We may be too far along in the contagion process to be vaccinated by the Federal Reserve and escape with only a mild case of the European flu.
I believe that is what attacked our markets last week. It is becoming increasingly evident the European crisis is not going to be solved using the current tools and European leaders appear powerless to accept the facts and produce a true solution that can stop the contagion.
Fortunately the U.S. consumer is alive and well as we saw from the Black Friday retail reports. Malls were packed across the country in what was described by analysts everywhere as "record spending." More than 152 million were expected to shop on Friday. Customer Growth Partners (CGP) said the period from 9:PM on Thursday to 9:PM Friday was the busiest 24 hour period in retail history. They said traffic checks showed sales to be running at three times normal with expected retail sales of $27 billion compared to averages of $9 billion. At one Macy's store there were as many as 10,000 shoppers in line when the store opened on Friday morning.
Other analysts were bullish but not nearly as strong as CGP. Estimates of 8% to 11% higher sales than 2010 were common. They attributed the increase in sales to the sudden trend to open stores on Thanksgiving evening rather than 5:AM on Friday. Many older shoppers will not get up to stand in line in the 5:AM cold but they will line up to shop late on Thanksgiving. Still there were more than 15,000 in line for the Mall of America in Minnesota when it opened at 4:AM. That was nearly double last year's numbers and the mall expected more than 200,000 shoppers on Friday.
We will get some hard numbers next week as the various stores and analysts begin to report their results. Also next week there is a very strong economic calendar with three ISM reports and three major employment reports.
Wednesday has the Challenger Employment and ADP Employment as well as two ISMs and the Fed Beige Book. Thursday is the national ISM and Friday the Nonfarm Payrolls.
The European calendar will also weigh on the markets with the finance ministers from the 17 eurozone nations meeting on Tuesday and all 27 finance ministers from the entire European Union meeting on Wednesday. The obvious topic is the continuing sovereign debt crisis. The leaders from the entire European Union will hold a summit on Dec 9th on the debt crisis.
The Beige Book and the Nonfarm Payrolls are the two biggest reports for the week. Analysts will be looking at the Beige Book activity for a clue on whether the Fed will implement QE3 when it meets on Dec-13th. There are growing expectations the Fed will introduce some form of monetary stimulus at that meeting in order to offset the growing weakness in Europe and its impact on the U.S. economy.
The Nonfarm Payrolls are expected to have risen from 80,000 to 117,000 thanks in part to normal seasonal hiring.
There was no stock news on Friday. However, as you would expect the news gravitated around potential winners from the Black Friday spending spree. One of the biggest sellers around the country was the Sony Playstation 3. Also a big seller was the new Call of Duty Modern Warfare 3. Large screen TVs were popular again with Sony and Panasonic the names mentioned most. Sony (SNE) shares spiked +4% on the news.
Green Mountain Coffee (GMCR) was flat for the day despite heavy sales of the Keurig coffee makers. Reportedly those coffee machines were top sellers in the kitchen departments and that is good news for GMCR. Every machine sold creates a new stream of future K-cup sales with more than 200 varieties for sale and growing.
AT&T (T) and Deutsche Telekom/T-Mobile withdrew their request for merger approval. By announcing this on Thanksgiving Day it suggests they were trying to avoid the negative publicity. AT&T has to pay a $4 billion breakup fee if the merger fails. The $39 billion merger is the focus of a DOJ review on antitrust concerns. FCC Chairman Julus Genachowski said last week he had concerns about the deal and would schedule it for a hearing. On Friday the companies released a joint statement saying they would "focus their continuing efforts on obtaining antitrust clearance for the transaction from the Dept of Justice either through the litigation pending before the US District Court or alternate means." The statement does not seem to coincide with their withdrawal letter but maybe they are just trying to soften the blow to their stock price.
Also on Friday there was another report out suggesting AT&T was going to offer to sell up to 40% of T-Mobile's assets in an effort to win approval. The asset sale proposal needs to be made before the November 30th DOJ hearing or risk developing even more negative sentiment.
A couple of recent IPOs have not been doing well. Groupon took a sudden turn for the worse last week. Nasdaq said 8.3% of the shares were shorted or 2.92 million shares. That data is for the week ended Nov-15th so the number has probably risen since then. Groupon is now trading more than $3 below the IPO price.
Linkedin (LNKD) continues to decline after the 24 million share lockup expiration last Monday. The shares outstanding only increased by about nine million so it appears owners of 15 million shares elected to sell some shares into the $71 secondary offering and delay their lockup on the rest for another three months until Feb-14th. That will be the next hiccup date.
Oil prices continue to hold over $95 as the sanctions mount over Iran. France announced a new round of joint sanctions against Iran and called on all its allies to stop buying Iranian oil in order to pressure the regime to halt the nuclear expansion. Sarkozy asked French allies to impose "unprecedented" sanctions, including freezing the assets of Iran's central bank and suspending the purchase of Iranian oil. U.S. Secretary of State Hillary Clinton said the U.S. was going to label the Iranian central bank a "primary money laundering concern." Similar labeling on North Korean and Lebanese banks caused other countries to sever ties and U.S. officials are hoping for a similar result.
Continuing problems in Syria, Egypt and Yemen are also providing support for oil prices. In Yemen rival army units began shelling each other in the first major battle since President Ali Abdullah Saleh agreed to resign. Under the agreement Saleh will transfer power to his vice president within 30 days. He will be the fourth dictator displaced by the Arab Spring.
Considering the dollar has rallied strongly for the last two weeks and closed on Friday at two month highs it is surprising that oil managed to hold its recent gains.
Dollar Index Chart
Crude Oil Chart
For months most analysts have expected the dollar to decline as the European problems were resolved. As it becomes evident the debt crisis is not likely to be resolved without some defaults by both countries and banks the value of the euro may not recover. Some analysts are now expecting the euro to reach parity with the dollar and that would be a 25% decline in the spread between the two currencies. That would cause not only a sharp decline in the euro but a sharp spike in the dollar. Commodities and equities would not do well in that environment. The drop in the euro and corresponding spike in the dollar will likely occur rapidly as news events unfold in Europe. Be aware of the potential for currencies to significantly impact our markets in the months ahead.
The S&P has closed in negative territory for the last seven trading sessions and has clearly broken from the prior trend. I warned last week that a decline under 1200 would turn me bearish and I have not changed that view. If this trend continues the next target is 1120. Unless Europe suddenly heals itself, not likely, or the U.S. suddenly disconnects from Europe, also not likely, then the odds are good we could continue lower.
However, logic rarely works well in determining market direction. If positive reports from Black Friday continue to pour in and the economic reports for next week show improvement then our markets could stabilize. This is year end and positive economics coupled with positive consumer sentiment could work wonders on the market BUT I think that is wishful thinking.
I believe investors were hoping the resignation of Papandreou in Greece and the appointment of a new government, along with the resignation of Berlusconi in Italy and appointment of Mario Monti, would fix Europe. Unfortunately those were just steps down a very long and winding road with no end in sight.
With daily headlines emphasizing the deteriorating conditions in Europe and the lack of a comprehensive plan by European leaders to fix it the future would appear to be more of the same with that potential for a sudden Lehman like event from a major bank or country throwing in the towel. We saw how fast MF Global imploded. That can also happen to banks overseas. Nobody really knows what stresses the European banking system is undergoing. We do know there is a daily cash drain as individuals and businesses withdraw money to avoid an unexpected banking disaster. Where is the breaking point? We saw Dexia fail several weeks ago and there could be more in the pipeline. Only a month before the collapse the banking authorities and the government assured the markets Dexia was solid. Four weeks later it collapsed and had to be nationalized.
Getting back to the U.S. markets a retest of 1120 would not be the end of the world but a decline below that level could setup a very unfortunate series of events. One writer highlighted the increasing volume of S&P puts being bought in the 600 range. Personally I believe a drop by the S&P to 600 would be the equivalent of an asteroid strike but we did trade down to 666 during the great recession. While I don't think we are headed for the Greater Recession there is always the possibility of some monster failure of the European banking system.
I believe that would make the U.S. banks/market an incredible safe haven but then I don't write the rules. When the U.S. imploded in 2008 the rest of the world declined as well. Does that mean a banking system failure in Europe would knock us back to 2008 levels? I don't pretend to know but there are trillions in derivatives, somewhere in the range of $300 to $600 trillion if you believe the rumors. How many of those would be triggered if the European banking system collapsed? If only a fraction of those credit default swaps, guarantees, hedges, etc, were triggered it could cause failures of major U.S. banks and there would be no bailouts of that magnitude.
I can't predict the future and in some of those scenarios described above I don't even know what the fallout would be. What I do know is that we can't cower under the bed while we wait for the next disaster. We need to focus 2-3 weeks ahead and trade the cards we are dealt. I would suggest using smaller position sizes and keep a lot of cash in your account until visibility clears. Loading up on positions either short or long would not be a good plan today.
I would be a buyer at 1120 if we did see that level. If we bounce we are going to see resistance at 1195-1200 so that would be the next decision point.
The Dow has the same chart as the S&P only not quite as ugly. Critical support at 11,400 broke and there was solid resistance at 11,335 on Wed/Fri. We closed at the lows of the day on Friday ahead of severe weekend event risk. The risk environment does not improve much for the next couple of weeks.
If the sell off continues we could see a pause at 11,000 but the eventual target is 10,600. That would wipe out nearly all of the October rally. The Dow has declined -9% from the October highs, -10% for the S&P, and normally that would be a pause point where an oversold rally could appear. I don't see anything in the charts to suggest it and in this environment headlines always trump technicals.
The Nasdaq barely slowed at round number support of 2500. Declining velocity accelerated with the break and it would appear the next target is 2340 or even 2300. It is tough to say since tech stocks are significantly oversold and beginning to represent compelling bargains.
At what point do investors say to heck with the headlines I am going to buy something? Obviously the early buyers will be wrong and those that wait too long could miss the rebound. I personally think Apple at Friday's close of $363 on the 200-day average represents a compelling opportunity. At 12% of the Nasdaq 100 the market will react to other investors seeing that opportunity and acting upon it. A break below $350 would put the Nasdaq in free fall so that is the guideline for next week. Watch Apple shares for a clue to investor sentiment.
The corresponding level on IBM would be $171 and a compelling buy that would support the Dow.
On a Nasdaq rebound 2475 and 2535 would be initial resistance.
The Russell 2000 has raced ahead to a lower relative close than the other indexes. However, the Russell had been lagging on the upside so this is just investor sentiment being extended into the selloff. Russell 650 should be decent support but with the relative weakness we could see an extension of the selling and a retest of the 600 level and the October lows.
The Dow transports have lagged the broader market in the decline but a break below 4530 would quickly catch up. In theory, having the transports lag in the sell off with oil over $95 would appear to be a bullish sign in the midst of significant bearishness.
It is tough to assign much validity to the market for Friday with only 2.9 billion shares traded. Thanksgiving Friday never has any material volume and this was right in line with last year at 2.8 billion shares. It is a throw away day and we really should not try to pick a direction based on Friday's performance.
The direction for next week will be headline driven. There is no magic number or mythical line on a chart. If you draw enough lines eventually some of them will be hit but that does not make us experts. In this case headlines trump technicals. Whatever happens over the weekend will determine our fate on Monday. The market is significantly oversold so a short squeeze could appear at any time.
Reduce your position sizes and choose your entries carefully.
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