Market in DOWNTREND – Europe is approaching the point of no return

0 CommentsWednesday • April 11, 2012 • by ewmoe

Lately it has seemed that everything is fine in the world economy. Stock markets have been blazing over the last three months, yields on junk bonds are low, unemployment is falling and the economy is growing. But the underlying structural problems that tell us what is in store for us are not improving one bit. Debt levels are way too high while many of the major collateral classes are falling, or are likely to fall, in value. We are looking at a recipe for another great financial crisis; one that will make the previous crises pale in comparison.

While the uptrend met some resistance a few weeks back, the action since has switched the model to indicate a new DOWNTREND. The model switched last Wednesday and market action since then has confirmed the trend. This has marked the end of an uptrend that started on December 20^th. The Chinese market, which has been a leading indicator for years, gave a hint of an imminent top in the US markets as it topped out on February 20^th.

It is impossible to say whether this is a start of a steep correction or if it is just a natural breather in a continuing ascent. After the market actions over the last few days it would not be surprising, if it were soon to make a small rebound. But until the market has shown renewed signs of strength and an uptrend is in place again, investors should be careful with their stock holdings. Earnings season has now been kicked off with Alcoa reporting after the close yesterday. The numbers coming in over the coming days and weeks will most likely have a significant saying in the ongoing direction of the market.

The stock market has seemingly been driven by good news over the last three months, but more importantly I think it has been fueled by operation Twist, which has allowed investors to unload long-term treasuries in exchange for cash. And even more significant than the Fed has been the European Central Bank (ECB). Between July 2011 and now, the ECB has expanded its balance sheet by USD 1.3 trillion by handing out USD 645 and USD 712 respectively in its two largest programs called Long Term Refinancing Operation (LTRO) 1 and LTRO 2. Most of this money has been loaned to banks over the last nine months. No wonder that the stock market sees results. The balance sheet of the ECB is a staggering USD 4 trillion, 31% larger than the German GDP!

And this brings us to the crux of the problem: The European debt situation. Many countries and banks in Europe are doomed and the reason remains the same. Loads of bad debt. The issue is highly complex and at the same time very simple. Consumers, banks and countries have taken on too much debt and the financial system is now, and has been for a while, struggling to sustain it. Might sound like a broken record, but unfortunately still way too few people seem to give it the attention it deserves or have tried to understand the implications of the most likely outcomes of this mess.

On April 5^th, the day that marked the turn of the model, the German Bundesbank refused to accept Greek, Irish or Portuguese sovereign/bank bonds. Also last week, a 2.6 billion euro Spanish bond auction went worse than expected. Trouble in Euro paradise.

There are so many countries in Europe now, which are in deep trouble due to too much debt combined with contracting economies. The ECB keeps hoping that the situation can be saved, but I believe we are getting closer by the day to the event that will break the system’s back. The main problem is not only the economy in the PIIGS; it is that European banks have a very large exposure to these countries’ debt. In addition to this, banks need to raise significant amounts of capital in the coming years to comply with Basel III and other regulations. The reason why the ECB is taking desperate measures is because the situation calls for it. The European Banking system is over USD 46 trillion in size. EU GDP is in comparison only about USD 16 trillion. The problem is not only the unbelievable size of their assets (remember that bank assets are someone’s debts) but also the banks’ debt levels; according to the IMF their leverage ratio is 26 to 1. This compares to a 13 to 1 ratio for American banks. And we thought American banks were in trouble… Which, by the way they are, it is just that the Europeans have dug a hole that is a little wider and much deeper.

One of the countries that is in trouble is Spain. It is among the ones that stand first in line to fall now after Greece—and do not think for a second that Greece is home free and will not default again, because it will. The country has experienced five straight years of contraction, with a total contraction of 17%; this is by anyone’s definition a depression. It has unemployment above 20% and unfunded liabilities around 800% of GDP.

Spain is in a recession; unemployment has reached a depressing level of 23%. For those under 25 years of age, the unemployment rate is 51%. It will probably not be long until they will take to the streets. But this is likely not the biggest problem. Spain, like so many other western countries, saw its economic growth coming from the expansion of the real estate sector, and since the market turned downwards a few years back, Spanish home prices have fallen only around 15%. Why so little? Because the banks can’t afford lower prices, which would force them to have to write down their balance sheets, which in turn would prove to have devastating effects given the already extreme leverage ratios of Spanish banks. Like the ECB, Spanish banks are hoping for a revival in the economy before they are forced to make these potential write-downs. A revival of an economy, which is already in a recession and with a government with high and growing debt level, who tries to battle their fiscal deficit by reducing it from 8% to 5.5% through cost reduction, is extremely unlikely; especially when you take into consideration that private debt already is at 220% of GDP.

This is the situation in two of the PIIGS countries. The situation in Portugal, Ireland and Italy is dire as well. The problem in Europe is that banks all over the continent have exposure to these economies, which are on the verge of and which should already have declared bankruptcy. And your money is not necessarily safe in the US either; US money market funds have a very large exposure to European debt.

What is the proper thing to do? The answer can be found by looking at what the players who are already in trouble are doing. European banks are rushing into cash. The Wall Street Journal reported on February 21^st that eight of the largest banks in Europe were holding a total of USD 815 billion in cash and deposits at central banks at year’s end, up 51% from just one year earlier.

This indicates that banks are very uncertain about the future, or more correctly they fear for their financial future. And if the banking sector is afraid about the future and takes precautionary measures, you can be sure that you should also do so. A follow-on effect of the banks’ action is that less capital is available for lending, translating to less money available for economic growth.

We are in a negative spiral. The problem is just that we have not realized it yet. We are sensing that there are forces in motion; we just don’t know what kind of forces or what direction they are taking. Einstein explained to us that if you are in a windowless vehicle and feel a force pulling down on you, you could be accelerating upward or you could be experiencing the pull of gravity – the two forces are exactly the same. We are in the same situation. We are in a windowless vehicle desperately hoping that our economic theories will be able to predict and manipulate the forces to pull (or push) us in the right direction. Until we realize which forces we are sensing, we are best protected by keeping our savings and investments in cash. Find the safest banks and keep your cash there, for now. If the scenario that I expect unfolds, that will not be safe enough either. You will then have to switch the filling of your mattress.

Austerity measures in Europe, while being the right thing to do, will contrary to many economists and politicians’ beliefs, cause another recession of which no stimulus can save us from. The debt contraction coming in the wake of the recession will lead to a global deflationary depression -not inflation like most people expect. No one will be spared; obviously not Europe, but neither will the US, Japan, Russia, China, Asia in general nor Latin- or South America.

That USD 1+ trillion in ECB handouts is not sufficient and has simply calmed the storm and cause a temporary stock market uptrend. The same will happen with any future efforts of quantitative easing from the ECB or the Fed. The problems we have seen in Greece will spread, and Spain and Portugal are likely next in line. Politicians in Germany, France as well as in the PIIGS countries will have to come back to deal with the bailout problems again and again until they are forced to give up or are voted out of office. And we might see a change in French politics with the election coming up. That would probably just be a good thing. We have been doing nothing than kicking the can down the road ever since the last financial crisis, ensuring that the next crisis will be of a magnitude greater.

It is about time that we all realize that there is nothing wrong with a country declaring bankruptcy. A one-time pain (bankruptcy) is much better than extending the pain over many years (saving a system which is broken due to too much debt by raising more debt) and creating a situation where the outcome will be even more painful that the initial bankruptcy would have been. Bankruptcies of sovereign states is nothing new, or that dramatic. It has happened endless times over the last two centuries and have, all else being equal, never had any long-term negative implications. Investors are quick to forgive and reinitiate lending. Contemporary politicians and economists, all around the world, are still swept in the illusionary belief that financial markets can be manipulated to their whim.  This manipulation will continue until they have pushed the system beyond the point of no return, and financial and economic reality has once again had to be relearned—the hard way.

Be aware, the point of no return is fast approaching.