Market Update

November 22, 2010

Wall Street worries about the size of Ireland's bailout.
Stock and bond markets ended last week on a positive note but prices were volatile as investors grew increasingly uneasy about the sovereign debt woes plaguing Europe. Ireland is the latest European country to fall under the scrutiny of bond investors (big banks) who are concerned that the country will not be able to repay their debt. Ireland's debt became unmanageable.

Interestingly Ireland did not have a sovereign debt problem until the government decided to bail out their largest banks more than a year ago. Prior to the credit crisis, Ireland's debt was comparatively small (only 7% of the size of their economy), but during the midst of the credit crisis Ireland decided to bail out their banks and transferred the banks bad debts to the citizens of Ireland; this increased the size of the nation's debt to 100% of the size of their economy and this is simply too much.

Ireland agrees to a bailout but concerns about other countries have not gone away.
Ireland agreed last evening to accept a smaller than expected bailout from the EU and the IMF but stock prices fell this morning as investors became increasingly worried about other European countries with similar problems.

Noted economist Nouriel Roubini painted a dim outlook for the European sovereign debt problem last week. He believes that if the European Union and IMF's bailout plan fails to inspire confidence in the debt of smaller countries like Greece and Ireland then the crisis could spread to larger countries. He believes that Portugal and France would be next in line for help and, following them, Spain. He estimates that Spain's debt alone would be too much for the EU and the IMF to handle.

How does this affect us?
If the problems in Europe spread, this can create some tough headwinds for stocks, and inversely this can be a boon for U.S. bonds; it really depends on the magnitude of the crisis. Right now we see a tug-of-war between stocks and bonds. Following a very strong October we saw stock and bond prices reach a short-term peak during the first week of November then prices weakened a bit as profit taking entered into the markets but U.S. bonds began to recover as the European debt crisis resurfaced last week.

Meanwhile we have our own bailout plan.
Make no bones about it the Fed's decision in August to embark on another round of quantitative easing is in fact a bailout of our national debt. We are doing the very same thing, for the same reasons here in the U.S. that Ireland, the EU and the IMF are doing in Europe. The United States is playing the role of Ireland while the Fed is playing the combined role of the EU and IMF. We in this country are simply calling it an obscure term "quantitative easing" but this does not change the fact that our central bank is printing money to boost U.S. bond prices directly and to indirectly boost stock prices as well.

We have been down this road before.
The Fed's first bailout plan (QE1) was developed in the spring of 2009 in an effort to boost stock and bond prices. The plan was successful but just as Japan learned in the '90s these plans do not create lasting results. As soon as the QE1 program ended in April stock prices started sliding back down that is, until, the Fed announced a new, much smaller, plan in August; that plan is now referred to as QE2.

Quantitative Easing is creating havoc for investors.
Never before have we seen this high of a level of intervention into the stock and bond markets as that being done today by the Fed. We see on nearly a daily basis money flowing into stocks precisely 20 minutes before the close to minimize any losses on down days and to boost prices on positive days. Trading in stocks is very thin as most investors are shunning stocks for the relative comfort of bonds but this too has contributed to the volatility of today's market. Quantitative Easing is artificially boosting stock prices and throwing technical and fundamental analysis of the markets into a tizzy. We have to be careful to avoid putting too much credit into the short-term effects of these programs and try to look beyond their temporary effects. Because of the artificial nature of these quantitative easing programs, the levels of risk in the stock market remain much higher than in years past.

The week ahead.
Thanksgiving is normally a quiet week for the markets but this week promises to be different. Tomorrow we have the Fed's release of the minutes from their last meeting wherein many are looking to find details about the Fed's outlook for our economy. We also have the release of the government's Gross Domestic Product measure of economic activity for the 3rd quarter on Tuesday. Many are hoping to see the GDP figure revised higher than previously estimated.

On Wednesday we have the release of more economic data with the Durable Goods Orders report which should give us an indication of the consumer's willingness to buy big ticket items. And of course we still have the continuing saga of Ireland to watch.

Happy Thanksgiving!
Greg

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November 10, 2010

The dollar starts to rise on concerns about European debt.
The lead story in the financial press is changing from concerns about the U.S. economy to concerns about Europe. The European debt crisis was put on the back burner in April after the World Bank announced that they would assist European countries in their effort to refinance their sovereign debt, but those promises of assistance came with conditions. It now seems that those conditions are not being met.

For several weeks we have seen bond prices for Greek, Portugal and Irish debt plummet to crisis levels and now this news is garnering attention of the mainstream financial press. This creates a perfect excuse to buy the dollar and sell the Euro. Traders who just a few weeks ago hated dollars are now buying the dollar and this is putting a lid on stock and bond prices.

This chart shows the dollar's future index (the black line), along with the S&P 500 stock index (tan line) and the Treasury Inflationary Protected Bond ETF (in blue). This chart shows that the slide of the dollar which began in early June ended in mid-October.

While it might be a bit early to say that the dollar's rally has finally begun, it is clear that the circumstances to support a dollar rally are coming into place. What does this mean for investors? It means that stocks are headed lower unless the stock market can de-couple from the dollar.