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Waiting for Eurobonds and Flying PIGS


Without decisive action out of Europe, rallies will be hope-filled but short-lived.

When fundamentals are controversial, cloudy, and just plain confusing, what is an investor to do? Is this a great buying opportunity or just the beginning of a much longer correction?

The US economic picture looks fair to good, with stable GDP growth of around 2.5% and steady improvement in manufacturing, housing, employment, and consumer finance. S&P 500 earnings estimates currently have the index trading at a very attractive multiple of 13 times 2012 projections (which have come down in the past year from EPS of over $110 to $103).

But then there's Europe. We know a recession is baked-in for 2012, but their debt crisis represents a wild-card situation where any day could spark a banking contagion meltdown. As Europeans feel hostage to Greece, the US feels somewhat captive to all 17 countries comprising the globe's second largest economy at $12 trillion GDP.

The bull market is officially on hold again as we wait for them to make up their minds about a few things.

It is uncertain times like these that cause me to look at the price chart of the most important stock index in the world, the S&P 500, to tell me what large investors and asset managers think of the fundamentals. After surviving a 2011 second half correction that nearly turned into a bear market in October, US equities shook off European fears as it became clear that leaders over there would start to address their crisis and prevent systemic effects.

I was a buyer last fall below S&P 1,200 because I thought the fears were overblown and Europe would get things right. In a sense, I over-simplified matters because I saw extreme fundamental and technical value at S&P 1,100 and I assumed that the European Central Bank (ECB) would start to act more like our Federal Reserve.

But the past month has seen a slow revival of fear, as if the market was pricing-in a coin-flip's chance of Greece falling out of the euro. And I also realized that Europe's problems are much more complicated to solve than the ECB simply getting the Fed's religion of quantitative easing.

A Curious Bull-Bear Stalemate

After finding support below 1,300 and surging above 1,325 early in the week, the S&P 500 has been swinging back and forth in knee-jerk reactions over expectations and rumors out of Europe about if, when, and how Greece might fall out of the eurozone and cause a domino effect of banking contagion that could affect the entire global financial system.

And every day the index closed somewhere between 1,315 and 1,320, as if it had found an equilibrium level and was merely waiting for some catalyst to make it move definitely one way or the other. One of the things the market seems to wait for is confirmation that Europeans will decide to let their central bank support the financial system and economy in any conceivable or preventable disaster scenario with massive quantitative easing. In short, the world wants to hear a "yes" to these two words: eurobonds.

Wednesday afternoon as the index fell back below 1,300 and the EU summit dinner meeting was about to begin in Brussels, stocks suddenly surged in the last hour on comments from French and Italian leaders that they were prepared to "do whatever it takes" to stem their crisis. The S&P quickly surged back above 1,315.

Then, following the umpteenth EU summit in the last two years of their debt crisis, came a sober conclusion from Jean-Claude Juncker, Luxembourg Prime Minister and President of the finance ministers of the eurozone known as the Euro Group.

Speaking to reporters, Junker said that joint debt sales "didn't find much support," particularly in the German-speaking area, while the French-speaking area was more enthusiastic.

The market did not sell off though dramatically though, at first making a run for 1,325 and then drifting down to 1,310. Which was very interesting I thought. Could we be back to the days of the past six months where sufficient fear about Europe is priced-in? Or do large investors actually believe that the ECB cavalry is coming to the rescue?

And then Thursday afternoon became a repeat of Wednesday with late day statements from European leaders sounding the rally cry. This time it was Italian PM Mario Monti in an Italian TV interview essentially refuting Juncker with these words:

"A majority of EU leaders backed the idea of joint euro-area bonds. Europe can have euro bonds soon."

Reporters ran with this story and interpreted Monti's words as "Merkel left the door open for euro bonds!"

Read My Lips: "Nein!"

But before US markets could even open Friday morning, word came that German Chancellor Angela Merkel still had no intention of talking about issuing centralized debt from the ECB.

"This means very hard work for Europe. It makes no sense to paper over everything with euro bonds or other instruments that ostensibly show solidarity, only to find Europe in even more difficult straits than we are in today."

But as Bloomberg reports, there is a lot of discussion lately about an under-the-radar debt relief proposal that may have markets a little more optimistic lately:

While she refused to back joint euro-area bonds at a Brussels summit on May 23, Germany's opposition parties wrung a concession from the chancellor on her return to Berlin (Thursday) to reconsider a separate proposal on common liability for sovereign debt.

The blueprint, published in November by Merkel's council of economic advisers, involves a so-called European redemption fund that would help governments scale back outstanding debt to below 60 percent of economic output in return for constitutional commitments on economic reform. The government and opposition agreed to study the fund and discuss it further on June 13.

Merkel, who poured cold water on the redemption fund when it was unveiled last year, again doused joint debt liability in a speech yesterday, saying that the causes of the debt crisis "can't be redressed with one big bang."

But, she may allow herself to be forced into compromise. After all, it is far better to fight and lose on one's principles, then just to give in to the undisciplined hordes.

This is the simple logic I have used to evaluate the German stance in the past year:

Germany wins in several scenarios as things melt down. They get concessions on fiscal austerity and they get a lower euro. And if they seem like the bad guy letting Athens or Madrid burn to the ground while they stand by and watch, they don't care and won't give in... unless forced to.

Maybe Merkel wants to be forced by events and politics so she doesn't have to bend and appear to compromise. That is a dangerous game of chicken. But she is comfortable with that game as we saw last fall.

What's changing is that the Germans can't run the show forever. Compromises may be around the corner. But realistically what we will see is new financial agreements and innovations. Everything -- anything -- but eurobonds.

Low Expectations, Low Fear

The chart and all this news flow tell me two things:

1. Intelligent market participants are not as afraid of Greece falling out (getting kicked out) of the eurozone as they were in early May. How do I know? Because the consequences would be so severe for the European financial system, as all institutions made emergency adjustments and prepared for systemic fallout. If Greece were really going, the market would not be holding up so well above 1,300.

Sure, we have to wait and see if Greeks can form a new government with elections June 17. But I think the market is telling us that confidence from Merkel and others indicates they will do whatever is necessary to keep Greece aboard. The price of not getting a pro-austerity coalition in Greece to cooperate is deemed so great by major investment houses such as Morgan Stanley (MS), Barclays (BCS), Goldman Sachs (GS), JPMorgan (JPM), and Jefferies (JEF) that the market would surely be another 10% lower if they thought the worst was coming.

2. Intelligent market participants are not expecting eurobonds any time soon. They know Merkel and Co. won't go that way -- at least not this year. The EU and the ECB have a lot of other policy options up their sleeve before they are forced to capitulate to the calls for Fed-style QE, to say nothing of the political hurdles required to change EU and ECB charters and laws.

So what are they expecting and what are they afraid of?

At the risk of over-simplifying again, they are expecting some measures from European financial leaders before June 17, which could include the following:
  • Some form of emergency FDIC-type bank deposit guarantees to prevent bank runs.
  • An announcement about new plans for a centralized banking system that can handle/prevent bank failures.
Here's ECB Executive Board member Peter Praet speaking at a conference in Milan on Friday:

Europe needs to move towards a financial union, with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks. Decisive and far-sighted reforms like these, unrealistic until a short while ago, are now gaining support. Reacting to the pressure of events may seem unattractive, but it may also be the only way forward.

According to Reuters, "Praet told the conference that there was 'no escaping a banking union' and that a resolution framework was an essential part of a single market."

And what are big market participants afraid of that has them neither selling nor buying too many stocks at S&P 1,315 and keeping the bears honest in a very narrow range?

They are still afraid of course that European leaders will continue to drag their feet and let the crisis grow worse, especially while the recent Spanish bank failure could be just the tip of the iceberg there.

And they are probably accepting the reality that even if some positive news out of Europe next week sparks a rally, we are going to be in this corrective phase for a while until more certainty is achieved about Greece and European banking system.

I think the chart above is telling you the market is setting up for another fear-driven slide lower. It's a classic pattern in many ways. In the one-month picture you see above, we have this week looking like a bear flag or rising wedge in the context of the drop since early May. And we have four consecutive days with a very narrow range (at least in the candle bodies which represent the open and close).

Bottom line: Without decisive action out of Europe, rallies will be hope-filled but short-lived. The summer trading range is likely to be 1,350 down to 1,250 as Europe rights the ship.

Why not lower? Because right now the market is telling you Europe will make some necessary adjustments and prevent systemic meltdown. When price and market behavior say something different, I'll adjust and let you know.

Editor's Note: For more from, click here.
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