Sage Weekly Letter – 7/22/2012

• Posted by Robert Sinn
• on July 22nd, 2012

Last week really began on Tuesday morning with the Fed Chairman’s testimony to the Senate Committee on Banking, Housing, and Urban Affairs. Bernanke highlighted the usual downside risks to the economy and once again urged Congress to “address the nation’s fiscal challenges in a way that takes into account both the need for long-run sustainability and the fragility of the recovery”, however, it was the following two quotes which stood out from the rest and left market participants wondering:

“In all, the PCE price index rose at an annual rate of 1-1/2 percent over the first five months of this year, compared with a 2-1/2 percent rise over 2011 as a whole. The central tendency of the Committee’s projections is that inflation will be 1.2 to 1.7 percent this year, and at or below the 2 percent level that the Committee judges to be consistent with its statutory mandate in 2013 and 2014……

Reflecting its concerns about the slow pace of progress in reducing unemployment and the downside risks to the economic outlook, the Committee made clear at its June meeting that it is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” Federal Reserve Chairman Bernanke July 17, 2012

It still remains to be seen whether the Fed is indeed prepared to take further action, however, there can be no doubt that the odds of further action have increased in recent weeks as inflation data has continued to cool (CPI now running at 1.7% year over year) and employment numbers remain quite soft.

It is important to remember that QE2 was launched in late 2010 primarily in response to a deflation threat; therefore, if the Fed begins to see inflation coming in toward the lower end of its 1.2 to 1.7 percent range another round of QE will quickly become a foregone conclusion. Moreover, the continued strength in the dollar and decline in the euro has begun to make itself felt across corporate America with companies such as Ford ($F) facing an uphill battle with regard to sales volumes and pricing throughout Europe. Additional Fed balance sheet expansion would likely serve to at least halt the dollar’s advance – I believe that this factor will also play a large role within the FOMC as the committee debates additional easing actions.

Last Friday markets were reminded that the eurozone debt crisis is still lurking in the shadows even if we don’t hear about it every day. The following two charts help to illustrate some of the enormous challenges facing Spain:

 

Recall that housing prices in many areas of the country fell by more than 50% after the US housing bubble burst – given that by most accounts the Spanish housing bubble was at least as frothy as our own, it looks like Spain has additional pain ahead which means more bank failures and bailout funds for the few left standing.

As the Spanish economy contracts further the regional governments are having substantial difficulties funding themselves and we are now seeing the regions begin to line up alongside the banks for bailout funds. Expect to see more of this over the coming weeks and I believe it is increasingly likely that Spain will fall into a ‘troika program’ before the end of the year as it finds itself increasingly shut out of capital markets.

With the situation in Spain and throughout much of the eurozone periphery remaining highly stressed it is incumbent upon the ECB to cut rates all the way to the zero bound. However, interest rate cuts will have limited effects particularly in the context of a problem of capital flight from rapidly worsening economies in Southern Europe. Bank bailouts and liquidity provisions will only go so far, the weaker eurozone members need more competitive export economies. As Barron’s pointed out last week if $EURUSD were to fall to parity it would go a long way toward fixing much of what currently ails the eurozone. How does the ECB go about engineering such a currency devaluation and would this set off another round of competitive global currency devaluation? After all, heavily indebted countries always want to have a weak currency because it helps to redress imbalances and inflation makes it less painful to be a debtor.

Current Market Structure

The S&P 500 managed to slightly surpass its July 3rd high before pulling back roughly 1.5% to end the week at 1362 – bears will point to an assortment of potentially bearish technical occurrences last week including:

$SPX continues to find resistance at the upper median line of the Andrew’s pitchfork drawn from the May 2011 high, August 2011 low, and April 2012 high:

The Nasdaq-100 ($QQQ) found resistance above the 65 level once again and pulled back hard into Friday’s close printing a large bodied bearish candle:

The recent significant underperformance (2.71% since July 6th) by the Russell 2000 ($IWM) vs. the S&P 500 ($SPY) is concerning and somewhat reminiscent of what we witnessed during late-July 2011 before the big August plunge:

Meanwhile, some positive signs can be found in commodities ($CRB) and the recent strong performance by energy stocks ($XLE):

While commodities and energy stocks are not exactly the desired market leaders, given that much of the current bull vs. bear debate centers around disinflationary pressures, deflation, and global growth – the fact that commodities (oil in particular) have picked up in recent weeks certainly does not lend itself to the bearish argument.

It is not difficult to make a bearish case for equities right now given the renewed eurozone concerns, a lackluster earnings season thus far, the impending US fiscal cliff, etc. However, with sentiment about as poor as it has been at any point over the last two years and many already loudly calling for a repeat performance of last August, it seems to me that a large decline in equities is unlikely. Whereas, a much more likely scenario for the remainder of the summer is a continuation of the frustrating range trade with declines quickly finding support and advances running into resistance just shy of $SPX 1400.

In summary, from my estimation the current market situation is virtually perfectly balanced in terms of the merits of both the bullish and bearish camps. It is in the context of such an environment that I believe it is most important to employ market neutral strategies (or with as little directional bias as possible) and/or participate as little as possible until at least some modicum of clarity arises.

My most important chart for the week ahead is the Spanish IBEX, while Spanish yields make new all-time highs Spanish equities have yet to make new lows – it will be important to see whether the IBEX makes a higher low, double bottom, or plunges to new lows over the coming days/weeks:

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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