If you believe policymakers will once again bail out the markets, it is important to understand the limitations associated with each possible policy response. Writing for the Wall Street Journal’s Brussels Beat, Stephen Fidler touches on the problems associated with the narrowing list of options for European leaders. The drawback with euro bonds is one of timing:
The deliberations at Wednesday night’s European Union summit suggest most options to increase government burden-sharing are a long way from fruition. That includes the proposal that has received the most attention: euro bonds… Even if Germany, Finland and Austria dropped their objections today—a development of which there was little sign on Wednesday night—constitutional changes and other interim steps would mean the first euro bond couldn’t be issued for years. Some analysts say a more explicit signal that the euro zone is heading toward euro bonds, and a road map laying out how, might help bolster confidence, but even most proponents don’t see them as a crisis-fighting tool.
Markets are not interested in “solutions” that will take years to implement. History tells us a debt crisis is nearing some form of conclusion when depositors begin to flee from troubled banks. One possible response to slow the flow of funds is to insure deposits. Fidler highlights a fair question:
How effective would euro-zone bank guarantees be for countries at risk of leaving the currency bloc?
Euro bonds are a long way off at best. EU bank guarantees mean little if your bank is no longer located in an EU country. That leaves the first family of all moral hazard, central banks, to do the heavy lifting. If the first two rounds of unlimited three-year loans (LTRO) “fixed” the problems in Europe, you would not be reading this article. Fidler reminds us another round of LTRO has a questionable cost/benefit ratio and a significant stumbling block:
The ECB’s main policy “bazookas” have flaws that may undermine their ability to settle the crisis. It could further flood three-year money into banks, through an extension of its Long-Term Refinancing Operations. But while most analysts consider the fund injections in December and February as essential to resolving a crisis of confidence in banks, the benefit to the bond markets of beleaguered governments such as Spain and Italy was short-lived. There is another obstacle to expanding this program…. To get loans from the central bank, banks need to pledge assets as guarantees. And their pool of eligible assets has shrunk significantly.
The gravity of the debt crisis in Europe is captured in the last sentence above. Banks are running out of collateral.
Another major problem that we pointed out in October 2010 is when banks use LTRO funds to buy questionable government bonds; it makes the financial sector even less attractive to investors and a normally-functioning capital market. The purpose of bailouts and central bank assistance is to take a step back toward, not away from, normally functioning markets - LTRO has failed miserably on that front.
When the ECB decided not to take part in the Greek bond haircuts (they were paid in full), it reduced the effectiveness of the the central bank’s intervention into the bond markets. If the ECB steps in and buys large quantities of Italian bonds in an attempt to lower yields, it pushes other investors further back in the future haircut line. If the ECB will not take part in future writedowns, then the other bondholders must take bigger haircuts. Fidler sums up the problem:
If the ECB steps in to buy significant quantities of these bonds in an effort to calm markets, officials and analysts say private investors may well pull out. The reason: They fear subordination in the event of a restructuring.
The subordination work-around being talked about is for the European Stability Mechanism (ESM) to become a bank and lever-up using printed/borrowed money from the ECB. The ESM could take a place in the haircut lines with other investors, removing the subordination concerns. Fidler points out some obstacles here as well:
This approach would entail the ostensibly forbidden central-bank finance of governments and raise questions of moral hazard, potentially discouraging beneficiary governments from pushing ahead with economic overhauls.
Money printing and moral hazard; two terms that have unfortunately been used extensively in recent years. How long can central banks print money before inflation begins to accelerate in a 1970s-like manner? As evidenced in the slowing downside momentum in inflation-protection assets, such as silver and gold, the markets appear to be signaling an increasing concern about the future value of paper currencies. Markets are also thinking about the next round of inevitable market intervention from policymakers and central banks. Beginning at the 7:00 minute mark of the May 25 video below, we highlight numerous “bullish divergences” on weekly and daily charts, including charts of silver (SLV), a basket of commodities (RJI), agriculture (RJA), natural gas stocks (FCG), German stocks (EWG), Spanish stocks (EWP), gold (GLD), Italian stocks (EWI), small caps (IWN), regional banks (KRE), coal stocks (KOL), and telecom stocks (IYZ). The divergences tell us to be open to a bottoming process for risk assets, possibly unfolding over the next three weeks. Later in this article, we outline ways to monitor if the assets listed above are likely to respond favorably to the technical set-ups shown in the video. Historical examples of similar technical set-ups are provided below the video player, helping you answer the question - “How can these divergences possibly help me in the coming weeks?”
The charts that follow were originally presented on May 25. The chart below shows a weekly bullish divergence between price and a technical indicator, MACD Histogram, that foreshadowed the March 2009 low in the S&P 500. A bullish divergence occurs when price makes a lower low and the indicator makes a higher low.
The next chart shows evidence of slowing bearish momentum in the euro in the first quarter of 2009. The chart below turned out to be very useful to investors in stocks, bonds, commodities, and precious metals.
The current chart of the euro, shown below, may also turn out to be very useful over the coming months. The euro has been in a significant downtrend for the last thirteen months. The recent lower low in price has not yet been confirmed by MACD Histogram.
There are times when the best game plan for your next move in the markets is to take a wait-and-see stance. The outcome of the June 17 election in Greece is uncertain at best. The people of Greece may elect pro-bailout/austerity leaders, which would most likely be the most market-friendly solution. The decision tree for investors becomes much more uncertain and complex should Greek voters take a “throw the bums out” stance. If traditional parties in Greece fail to regain control, it could get ugly for global investors. To complicate matters, the markets do not know what the policy response will be after the Greek electorate has spoken.
In an environment where the unknowns are too long to list, we can use the markets to help us align with the proper investment path. The table below shows possible areas of resistance for a handful of key markets. If the market can begin to march above resistance, we will become more open to redeploying cash into risk-on and inflation-protection assets, including those listed previously in this article. The markets below, on average, would have to move 2.49% higher to clear overhead resistance.
We would also become more confident about a bullish market reversal if defensive assets, such as the U.S. dollar and Treasuries, begin to break down. If TLT and UDN clearly violate the levels shown below in a bearish manner, it will increase the odds for a pop in stocks, commodities, and precious metals.
Since deflationary forces are being driven by fears of more writedowns and possible unrest in Europe, we can monitor key support levels to assist us in making additional incremental reductions to the risk side of our portfolio. The table below is based on possible areas of support identified using DeMark Indicators, from Market Studies, LLC. The “Above” columns show the market’s current position relative to support “Level One” and “Level Two”.
How can we use the table above to monitor downside risk? The line in purple shows areas of support are roughly 2.72% below where the markets closed on May 25. The second layer of support is roughly 5.34% below the May 25 closing prices. If the majority of markets move below the values in the Level One column, we will be more apt to take another incremental step away from risk (raise more cash). Another incremental step may be taken based on the Level Two column.
The current trends in commodities and precious metals support the bearish and deflationary case for stocks. Central bankers are trying to create positive inflation, including asset price inflation. If commodities continue to decline, it reduces the probability of the bulls regaining control of the markets. If the levels in the table below are violated, the case for deflationary outcomes will improve.
Thinking in extremes is a good way to test your market preparedness. If you can answer the questions below without hesitating, you most likely have a good handle on the current environment:
- How would I manage my assets, including cash, if the S&P 500 moved from current levels to over 1450?
- How would I manage risk if the S&P 500 moved from current levels to 850?
The incremental approach discussed above, is one way to manage risk in an uncertain world.