Short Takes

Below is an updated table, as of 2:15 p.m. EDT, of important support levels for the EAFE Index (EFA) we originally presented on May 21. The bears still have an edge given the red boxes below. A good step for risk assets would be to change those boxes back to green.

Both the equal-weighted S&P 500 ETF (RSP) and German stocks (EWG) look like they could fall another 2% to 3% relative to support levels on their weekly charts. As shown below, RSP is challenging important weekly levels currently (above point A). The MACD (point B) and rate-of-change (point C) have not improved enough to drive much bullish interest yet. RSP also sits just above its 50-week moving average (thin blue line).

We reviewed numerous markets today. There are some reasons to be optimistic on the euro. There are some reasons to be pessimistic relative to Treasuries and the U.S. dollar, which leans bullish for risk.

Below is an updated version of the chart reviewed at the 3:15 mark of the video in a May 23 article. Intraday on Wednesday, VEU was clearly below the pink trendline (not shown - chart shows closing price only). The late day rally pushed VEU back above the trendline. Today’s strong finish, along with the market action over the last three days, suggests we should head into tomorrow’s session with a shopping list. If we throw the list away due to weakness, so be it.

The S&P 500 remains over 100 points below the April 2 high. We remain near and above the 200-day moving average. Our comments from earlier today still apply:

The point for U.S. investors is the path overseas seems to be gravitating toward two somewhat binary outcomes over the next two to three weeks.

1. A bottoming process similar to what the S&P 500 experienced in October 2011 or
2. An acceleration of declines similar to what global markets experienced in June 2008.

There is no question the elements are in place for an attempt at a bottoming process. We should learn a great deal about whether the next move is toward 1,400 or 1,200 relatively soon.

Given numerous ETFs from across the risk/inflation-protection spectrum have daily 9-9 DeMark counts, we will most likely wait to see how those ETFs react after reaching 9-13 exhaustion signals. The 9-13s could start appearing as soon as Friday, but the vast majority could come as early as Tuesday (markets are closed Monday). Further downside is implied to reach the 9-13s from the 9-9 counts.

Exhaustion signals worked very well at the October 2011 low. As we have stated in the past, the Demark 9-13s can give us valuable information if they “work”, marking a bottom, or if they “don’t work”. If the market blows through the 9-13s in a bearish manner, it will tell us a strong downtrend has begun. Under those conditions, we would be willing to raise more cash. For now, our cash positions are high enough given the odds of a market reversal will increase relatively soon. DeMark Indicators are proprietary tools from Market Studies, LLC.

From Reuters at 11:31 a.m. EST - Full Article Here:

(Reuters) - Euro zone officials have told members of the currency area to prepare contingency plans in case Greece quits the bloc, an eventuality which Germany’s central bank said would be testing but “manageable”. Three officials told Reuters the instruction was agreed on Monday during a teleconference of the Eurogroup Working Group (EWG) - experts who work for the bloc’s finance ministers. “The EWG agreed that each euro zone country should prepare a contingency plan, individually, for the potential consequences of a Greek exit from the euro,” said one euro zone official.

On May 6 with the S&P 500 trading at 1,369, we presented evidence of slowing bullish momentum. Thus far, we have seen little in the way of hard evidence to suggest a bottom was reached last Friday. However, we have seen enough to suggest remaining open to a bottoming process unfolding over the next one to three weeks.

The global markets continue to monitor the battle between inflationary forces (money printing, deficit spending) and deflationary forces (writedowns and defaults). You need to look no further than the $16 drop in gold Wednesday morning to understand the markets continue to bet on deflationary outcomes in the short-to-intermediate term. Said another way, the market is not expecting bold moves from the ECB this week or a sudden change of heart in Germany.

Not surprisingly, Germany has tempered the market’s expectations for significant policy initiatives coming from Europe this week. From the Wall Street Journal (WSJ):

Enthusiasm for the EU summit, partly responsible for some of the gains in global markets in the last two sessions, started to diminish following press reports stating that Germany has refused to share the debt burden of stressed euro-zone peers by ruling out common euro zone bonds.

In a separate article, the WSJ reminds investors the divide between Germany and the “let’s jointly borrow, spend, and print our way out of this” clan remains significant:

European leaders meeting here Wednesday are expected to back a package of initiatives to jumpstart growth across the flagging euro zone. But the planned display of harmony masks deep divisions within the currency bloc over more aggressive steps many policy makers believe must be adopted if the euro is to survive. At issue are radical reforms to the euro-zone’s architecture, from common bond issuance to a more potent bailout fund.

Based on Tom DeMark’s exhaustion counts, we have to be open to a bottom forming in stocks relatively soon (see video below for more details). However, we also have to respect that a more significant shift could be taking place in global trends. Relative to a possible bottoming process, European financial stocks are worth monitoring. Financials in Europe have been leaders on the downside since peaking in mid-March.

If the chart below of European financial stocks breaches the December 2011 low, it will mark a critical point for all risk assets. The break alone would not side 100% with the bears. Remember, the S&P 500 made a new intraday low in October 2011, but that low marked a bottom, not an acceleration of the downtrend. From where we sit, it is best to keep an open mind and see how it plays out, rather than anticipate what a possible new low in European financials would mean.

In a popular October 2011 video, we expressed doubts the ECB’s unlimited three year loans to European banks would “solve” the problem of too much debt. The chart above also questions the effectiveness of the ECB’s radical printing experiment. Bloomberg raises fundamental issues concerning the preparedness of European banks should Greece exit from the common currency (FXE):

Europe’s banks, sitting on $1.19 trillion of debt to Spain, Portugal, Italy and Ireland, are facing a wave of losses if Greece abandons the euro. While lenders have increased capital buffers, written down Greek bonds and used central-bank loans to help refinance units in southern Europe, they remain vulnerable to the contagion that might follow a withdrawal, investors say. Even with more than two years of preparation, banks still are at risk of deposit flight and rising defaults in other indebted euro nations.

The immediate risk for Europe’s banks, and for the euro region, would be a deposit flight from indebted nations such as Portugal, Ireland, Spain and Italy on speculation those countries also might quit the currency.

The May 22 video below covers Fibonacci retracement levels, trends, support, and DeMark charts (day, week, month) for the Vanguard All-World Stock Index ex-U.S (VEU). At some point, if foreign stocks remain entrenched in a downtrend, you have to question how long the S&P 500 can remain on a bullish island. The point for U.S. investors is the path overseas seems to be gravitating toward two somewhat binary outcomes over the next two to three weeks.

1. A bottoming process similar to what the S&P 500 experienced in October 2011 or
2. An acceleration of declines similar to what global markets experienced in June 2008.

Since there are so many unknowns starting with Greece’s “should we stay or should we go” dilemma, we are open to bullish or bearish outcomes. We are willing to add to our heavy cash position and we are open to redeploying cash fairly rapidly should the bottoming process scenario rule the day.

The video below covers:

1. All-World Stock Index ex-U.S.
2. Fibonacci retracement levels
3. Trends
4. Support
5. DeMark (day, week, month)

A well-connected writer for the Telegraph, Ambrose Evans-Pritchard, reported the following European proposals are being pushed this week:

The eurozone’s ‘Latin Bloc’ is in full revolt. The trio of French, Italian, and Spanish leaders - backed by world powers - are to push for a radical shift in Europe’s economic strategy at crucial summit on Wednesday. The package of measures includes an EMU-wide guarantee of bank deposits aimed at halting a slow bank run across southern Europe, as well as demands for full activation of the European Central Bank as a lender of last resort. They will propose eurobonds to finance an infrastructure blitz, a sort of Marshall Plan to revive confidence even if long-term benefits will take years to feed through.

Mr Hollande is balking at the coronation of German finance minister Wolfgang Schaeuble. “It is a litmus test. Hollande is flexing his muscles, showing that he is willing block the man seen as Europe’s symbol of austerity,” said Mats Persson from Open Europe. “The real battle is over the ECB. It is the only body that can act swiftly enough to underwrite the bond markets. But the crisis may have to get far worse before the Germans yield. It will take immediate contagion, far beyond Greece.”

Obviously, adoption of any of these proposals would be positive for U.S. stocks (SPY), and foreign stocks (EFA). The impact on the euro (FXE) could be mixed since additional money printing for the ECB is a doubled-edged sword helping keep the EU together, but possibly hatching the seeds for future inflation. The entire article is worth a look.

An Associated Press article threw some cold water on the idea of jointly-issued European debt:

Germany is making clear ahead of a European Union summit that Chancellor Angela Merkel’s government remains staunchly opposed to the idea of jointly issued bonds for the 17-nation eurozone.

The Wall Street Journal reported Monday that the Greeks may be having a change of heart relative to going out on their own sans the euro:

Greece’s conservatives, who support the country’s international bailout program, are drawing level in opinion polls with left-wing anti-austerity party Syriza, suggesting the June 17 election is wide open and could yet produce a government that meets Europe’s terms for keeping Greece in the euro.

If the conservatives win enough votes in June to keep Greece in the euro, the markets would most likely react in a very positive manner, at least in the short-to-intermediate term. The story above was one of the drivers behind Monday’s rally in risk assets.

You always have to be open to a change in the market’s tone, but one day does not make a new trend. Stocks have been overdue for a bounce. Our models showed slight improvement yesterday, but nothing too significant.

Since the weight of the evidence still leans toward weakening longer-term momentum, let’s take a look at a couple of potential positives to keep ourselves honest. We mentioned a potentially bearish set-up for the EAFE Index (EFA) on May 21. EFA was able to retake two of the DeMark TDST levels on Monday, which, all things being equal, is positive, especially if it holds into the end of the week.

From a long-term perspective, when the slope of the S&P 500’s 390-day moving average is positive, the market tends to have a healthy bias. The green arrows highlight areas of support by the 390-day and the red arrow shows resistance in 2008. Currently, the slope remains positive and price remains above the 390-day.

Last week, we noted the somewhat comical nature of the “pro-growth” talk coming back into favor in Europe. U.S. News & World Report does a nice job summarizing the Catch-22 facing policymakers:

The temporary hope for softer pro-growth reforms has created a kind of lull in the European drama, while everybody waits to see what magical plan might emerge from Bonn or Paris or Brussels. But no convincing new plan is likely to materialize, for one basic reason: Growth costs money, and nobody is willing to pay.

Traders often look for relatively easy ways to monitor the battle between “risk-on” and ‘risk-off”. Given that foreign stock indexes have lagged the S&P 500 in recent months and the center of the risk universe sits in Europe, you can make an argument the fate of the EAFE Index will determine the fate for the vast majority of risk assets. A partial list of the MSCI EAFE Index Fund’s (EFA) country weightings is shown below.

Tom DeMark, of Market Studies, LLC, has his own set of proprietary tools to determine and monitor key support levels. Last week, EFA closed below DeMark support levels on its daily, weekly, and monthly charts. The longer EFA remains below these levels, the more concerning it is for all risk assets in the short-to-intermediate term. Conversely, if EFA can recapture the levels shown below, it gives some hope for a risk rally.

On May 13, we described how to estimate possible downside “targets” when a market has a set-up for a head-and-shoulders pattern. A much longer-term, and potentially bearish, head-and-shoulders set-up appears to be forming on the weekly chart of EFA. The green lines show a possible downside target of 33.55, which represents a 27.5% decline from the pink neckline. The pattern becomes much more meaningful from a probabilistic perspective if price violates the pink neckline. For now, the pink line represents a possible area of support.

The weekly chart of the EAFE Index below shows possible levels where buyers may become interested (a.k.a. support). The most important levels relative to the head-and-shoulders pattern shown above are 45.90, 44.91, and 43.27. Each successive break of those levels would increase the probability of the head-and-shoulders pattern taking prices toward 33.55.

It is extremely important not to assume a bearish head-and-shoulders set-up will produce bearish outcomes. The term “set-up” hints at probabilities, not certainties. The S&P 500 Index had a head-and-shoulders set-up in early October 2011. The set-up did not produce bearish outcomes.

This article provides several key EFA levels to watch. With policymakers and central bankers waiting in the wings, it is best to monitor the levels with an open mind. A break of support becomes more meaningful if it can carry into week’s end. The violations of the DeMark support levels shown previously did carry into the end of a week, which means we need to respect that weakness could continue in global markets.

The gravity of the global debt crisis can be seen in the flip-flop game plans from policymakers. The reaction to the 2008 crisis was to try to “spend our way out of this”. That didn’t work, but it did succeed in pushing debt levels even higher. The second approach, championed by Germany’s Angela Merkel, is based on the “cut spending and restore confidence” theory. That isn’t working either.

Now we have come full circle with Tim Geithner and the IMF again calling for “pro-growth” policies. Pro-growth is a politically correct way of saying “spend money we don’t have.” According to the Wall Street Journal (WSJ), the Keynesian approach of the government leading the private sector to the promise land of growth, is now being embraced by the most broke nation of them all – Greece:

Mr. Tsipras, the head of Greece’s left party and an engineer by training, recommends a stimulus package to boost the Greek economy and has called for tearing up the country’s existing austerity-for-loans program. He has suggested scrapping plans to lay off 150,000 public-sector workers by 2015, and repealing recent measures to push down private-sector wages. He favors nationalizing the banking system so as to better direct lending policies, and speaks favorably of Franklin Delano Roosevelt’s Depression-era New Deal program and President Barack Obama’s stimulus package—something Mr. Tsipras said is lacking in Europe.

As we outlined in October 2011, the debt levels of many nations have moved into unsustainable territory. Thus, it is not surprising that policies from both ends of the spectrum have failed. Mr. Tsipras is also engaging in a full-tilt game of political chicken. From the WSJ:

The head of Greece’s radical left party—throwing down a gauntlet that could increase tensions between Greece and its frustrated European creditors—said he sees little chance Europe will cut off funding to the country but that if it does, Athens will stop paying its debts.

The video below looks at the current state of the markets (SPY) as we head into a G-8 weekend. Risk assets are oversold, but remain in prove-it-to-me mode. We will continue to err on the defensive side until the market or policymakers show us something of substance.