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The market is giving signs that it has discounted any possible good news and that the rally is over. Europe has been in one of its periodic, but temporary, quiet periods that has encouraged the market while slipping further into recession. At the same time the long-term policy moves required to unify the EU is not likely to be accomplished before a capital flight from Italy and Spain forces their hand. The global economy continues to slow, including, in addition to Europe, the U.S., China, India and Japan.While some form of Fed easing seems probable, the results are not likely to matter as monetary policy is becoming less effective and fiscal policy is paralysed. Corporate earnings estimates are starting to come down and results for this year and next will be highly disappointing. Technically, the market appears to be in the process of completing a top.
Greece once again needs more funds in order to avoid bankruptcy and an exit from the EU. If Greece is forced to leave the EU, it could set off a chain of events that would break up the zone. The EU agreed to give Greece a bailout of 173 billion Euros just a few months ago, and is now reluctant to put up even more funds. German Chancellor Angela Merkel’s coalition partners are opposing any more aid to Greece and there is major opposition to the move in the Netherlands, Finland, Estonia, Slovakia and Austria.
The problem for Germany is that, as an export-oriented economy, it needs the EU to stay intact. The creation of the EU was like a magic wand that bestowed a triple A rating on all of the southern tier nations and enabled them to easily raise the funds that enabled them to buy German goods. This enabled the German economy to grow substantially, and it has a lot to lose if the EU breaks up. Ever since the start of the crisis almost three years ago Germany had to know that it would have to absorb the major part of the cost of solving it, but has been working all this time to get the best deal it could. That is why we have seen the continual manoeuvring and delaying tactics by all sides as they tried to buy more time.
Now the end-game is rapidly approaching. Greece is estimated to run out of funds in October. The next ECB meeting is on September 6th; the German constitutional court rules on the EU rescue fund September 12th; and the next EU summit is on October 6th. Meanwhile the headlines are likely to mean a great deal of volatility for the markets. Even more importantly, however, the outcome will either cost Germany a huge amount of money, substantially weakening its outlook, or will result in the breakup of the EU.
At the same time, global debt deleveraging is placing a lid on world economic growth, which is now slowing once again as we have discussed in recent comments. In the words of Caterpillar CEO Doug Oberhelman, “The global economic outlook is more uncertain than at the start of the global crisis in 2008.” While experts disagree on whether China will undergo a soft or hard landing, the Shanghai Composite is now down almost 40% from its post-recovery peak in August 2009.
The market recently has been placing a lot of faith in the ability of the Fed to ease our way out of our economic problems. Although the latest Fed minutes indicate that imminent easing is a strong possibility, we believe the potential effects are being over-rated. Successive easing measures have had diminishing benefits and the Fed has used all of its conventional tools. Any remaining weapons are unorthodox, untried or subject to unknown negative consequences.
We also believe that the lengthy period of ever-increasing corporate earnings is coming to an end. Only 41% of the S&P 500 beat revenue estimates, the lowest in three years. Five companies issued negative outlooks for every company that was positive. Third quarter earnings estimates are now down 1.5% from a year-earlier. If so, it would be the first down earnings quarter in three years. In our view, we are going to see a cascade of downward revisions to earnings over the next six months.
It seems to us that the technical outlook for the market has also turned negative. On Tuesday morning the S&P 500 made a new recovery high before backing off. This high, however, was not confirmed by the Nasdaq Composite, the small cap 600, the mid-cap 400, the Dow Industrials, the Dow Transports, the NYSE Composite and the Russell 2000. The number of daily new highs has been dropping on the latest rally. Last Friday the VIX dropped to 13.45, a number that has signified market tops over the last few years. This indicates a market that is highly complacent and far from fearful as a lot of pundits would have you believe.
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