5 Must Know Lessons We Learned For This Week Part 2

Look What Happened The Last Time Markets Flattened Out Like This-Part 2 Lessons and Conclusions

What The EURUSD Is Telling Stock Investors

A continuation of Part 1

So, moving beyond weekly market movers, what are the lessons of the past week for the coming week and beyond?

Conclusions And Lessons

1. Italian Political Uncertainty Revives EU Risk Concerns

As noted in earlier, the majority of Italian voters have rejected the EU’s austerity program for Italy.  Spain’s pro-Brussels leaders are at risk of losing office from a corruption scandal too. The prevailing EU calm is not due to improving economics, which are in fact deteriorating. It’s about confidence in EU leadership being able to resolve things. These developments undermine that confidence and suggest further instability in the most sensitive EU nations, too-big-to-fail-or-bail Spain and Italy.

Rising Italian bond yields as a result of the recent election are also causing Spanish borrowing costs to rise.

2. Data Continues To Deteriorate, Risk Assets Resilient Or Finally Topping Out?

The most ‘big picture’ summary of what’s moving markets is that technical resilience and medium term upward momentum remain intact as they have for months despite steadily deteriorating economic data in most of the developed world, while underlying fundamentals that drive a sustainable uptrend continue to worsen and erode that trend’s credibility.

We could be seeing that trend getting ready to reverse.

Technical Picture: Weekly S&P Index Showing Fatigue

Look at the chart below.

S&P 500 WEEKLY CHART NOVEMBER 2010 – PRESENT

Source: MetaQuotes Software Corp, thesensibleguidetoforex.com

04 mar 02 2344

1. For the first time in many months, this bellwether risk appetite gauge has gone flat for three straight weeks, and in the past two weeks the weekly candles are “doji” types that reflect indecision and often give advance warnings of a reversal of a mature trend.

1. The last two times we had this much stagnation after a prolonged uptrend (March-April, September-October 2012), the index and most other risk assets pulled back. By the way, both periods were times of heightened EU worry, as we have today.

1. Remember the monthly version of this chart that we saw earlier in part 1.

Fundamentals Support That Technical Topping Out

There is plenty of underlying fundamental justification for a pullback.

1. GDP for 2012 was under 2%. Historically that has meant recession is on the way ever since 1948. See here for details.

1. Earnings growth expectations, the most important driver of stock prices, are being steadily cut back.

1. Much of the recent stock buying has been with borrowed money. Margin levels are rising fast. That means there are a lot of “weak hands” vulnerable to margin calls if stocks pullback. Such margin call based selling tends to feed on itself as it causes further pullbacks, margin calls, and thus more pullbacks.

1. Profit margins tend to be “mean-reverting,” and they are already at record highs, meaning a margin correction could be coming.

1. Price-Earnings ratios relative to 10-year average earnings are at 22 versus their long term average of 15. Again, these tend to be mean-reverting, so they’re due to fall.

1. Based on the forward price-earnings ratio, the S&P 500 is one of the most expensive markets in the world.

1. Even if you believe there is a ‘great rotation’ of funds into the stock market (we don’t – if Main Street is rotating in, guess who must be rotating out? The smart money), history shows such fund flows lag stock performance rather than lead it. In other words that’s a bearish indicator of dumb money chasing a rally.

1. This suspicion that the current buyers are the suckers is confirmed by high investor sentiment measures, suggesting that so many are already bullish that the supply of new buyers is gone.

See here for more on that.

3. Stimulus Related Headlines Continue To Dominate Markets

Over the past weeks we’ve seen:

In Japan, speculation about coming new easing and JPY devaluation is about the only thing driving both stocks and the various Yen currency pairs.

In the US, 2 weeks ago the FOMC meeting minutes fed speculation about the possible winding down of QE 3 drive stocks lower and the USD higher, and this past week Bernanke’s testimony that no such end was in sight supported US stocks.

True, markets have remained calm over the Sequester, but that’s because:

• The spending cuts for this year remain small
• The actual layoffs won’t hit until April (the federal employees get 30 days’ notice as of March)

Hints From The EURUSD? A Classic Case of Currency Markets Flashing A Warning

It’s interesting to note that the USD has continued its rally against most major currencies for over a month regardless of the weekly QE sentiment, but that’s likely more of a reflection of EUR weakness (fed by a combination of deteriorating data and political developments in Spain and now Italy) than QE sentiment.

The real driver behind that weakness, and specifically behind the EURUSD’s February power-dive, may well be the realization among currency traders that some kind of EUR debasing stimulus is due.

After all, the contrast between central bank policy and economic performance for the EU and US is glaring:

EU: Central bank holding its much higher interest rates steady, and shrinking its balance sheet as banks repay LTRO loans. Meanwhile, except for Germany, economic data is simply awful by most every measure even in core funding nations like France and Holland, never mind the usual horror show in the GIIPS block.

To add to the bleak picture, there are continuing signs that Europe’s voters are losing patience with the current game plan. France elected socialist PM Holland and now (as noted above) a clear majority of Italian voters have rejected former PM Monti’s pro-Brussels austerity program. Spain’s relatively pro-austerity coalition is in trouble, and the most recent German regional elections did not bode well for PM Merkel’s prospects in September.

US: Central bank not raising its much lower rates, is expanding its balance sheet as it pumps $85 bln/ month into the system and per Bernanke’s latest comments the Fed has no plans to stop. Growth is weak but still alive, as multiple key metrics like employment, spending, and GDP remain flat to slightly higher.

The above make it clear that:

• The pressure is on the ECB to offer Italian voters something for voting for EU friendly leaders rather than those who offer little more than a protest vote and a middle finger to Brussels’ recommended austerity programs.

• That means next week’s ECB meeting could well offer at least verbal attempts to lower the EUR, and perhaps raise hopes of a coming rate cut.

In sum, the EURUSD’s move lower is a hint of anticipated new ECB easing that would further slam the EUR but support EU stocks and, it is hoped, political stability needed to hold the EU together. At the same time, ECB head Draghi must balance that pressure to ease with PM Merkel’s political needs. Germans remain in favor of a hard currency and she cannot be seen as permitting the Euro to be turned into a modern day Italian Lira.

By the way, this is a classic case of why an awareness of forex market trends and their drivers can be very helpful to investors in stocks and other asset classes. The more international nature of currency markets compared to national stock indexes gives the currency savvy investor early hints of developments that can and do affect those indexes.

4-5: The Two Biggest Lessons And Conclusions Remain The Same

1. Beware of market risk: There’s far too much focus on why individual risk assets like stocks are a good buy, without sufficient warnings that these will fall along with markets in times of pullbacks

1. Beware currency risk: Just like you diversify by sector and asset class, you need to diversify your currency exposure, especially if most of you assets are linked to the USD, JPY, EUR, GBP or other currency at risk of being devalued faster than most others.

This isn’t mere speculation. For example, those in USD have suffered a steady wealth drain for decades. See here for further details on how the USD had been steadily shrinking long BEFORE we started with QE 1-3.

See here  or here for one good collection of a range of low risk, simple ways to do that either as investor or trader

This book also just won Best Forex Book Award for 2013, largely because it shows conservative traders or passive income investors how to protect themselves in safer, simpler ways than typically found in guides on currency or foreign investing. See here for details.

DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.