Have you ever noticed that when you kill the gas to a lawn mower or when the mower or chain saw runs out of gas, the engine races for a second before it dies? Apparently the engine runs lean (low gas / high oxygen) as the gas depletes—creating the surge. The same kind of burnout often occurs in the stock market. Apple, while a great company, experienced this type of buying pattern recently before the current sell-off. Farcebook’s IPO gives us the latest example of a buying frenzy. These kinds of blowout events often mark a turning point in markets. We witnessed that sort of thing Wednesday (and the previous Friday) with gold and silver. Short covering often explains the phenomenon. This past Wednesday, we saw the same thing in the stock market, and we may see a bit more today.
Of course, the talk of the day is the Spanish bank bailout agreement made this past weekend. This whole save-the-banks-at-the-expense-of-the-public syndrome wears very thin these days. Not only do more people realize that increasing debt does not a solve debt problem, but the unrelenting moral hazard of “robbing Peter to pay Paul” foments an increasing wave of public anger. In today’s newsletter “The Heart of the Matter” Dr. John Hussman put it succinctly:
It’s a little depressing to reflect on the fact that Spain is one of the four largest European nations, so it’s effectively being called on to lend to itself.
A country lending to itself—now there’s a novel concept.
Week in Review
Monday, stocks fell 2% in Asia in reaction to Friday’s sell-off in the west. Europe and the U.S. traded flat for the day. The big news in the U.S. came from the Commerce Department’s report that durable goods orders plunged 0.8% in April. Facebook continued its descent to perdition, closing below $27. The ten-year U.S. Treasury bond rate jumped over 4% to close at 1.53. Fear eased as VXO fell back a bit on moderate market volume. Reuters reported that the G7 will hold and emergency meeting Tuesday to discuss the deepening crisis in Europe:
The United States, which holds the G7 chair, has long pressed Europe to deal more forcefully with its crisis. President Barack Obama, seeking re-election in November, has pointed to Europe’s crisis as a problem for the weakening U.S. economic recovery.
…as if the U.S. with a $16 trillion national debt, a Federal Reserve with a balance sheet leveraged over 50 to 1, and a record number of people on food stamps has any business poking its nose into Europe’s finances. And why should Europe care whether or not President Barack Obama is re-elected anyway?
On Tuesday, stocks in Asia rose about 0.5%. European stocks treaded water. Three Federal Reserve presidents spoke. Markets seemed stalled awaiting on the outcome of the G7 meeting. The talks concluded with no joint action. Europe said they would handle their own business. Markets remained surprisingly calm in light of the news with U.S. stocks closing up slightly more than 0.5% on light volume. Facebook closed down again—this time below $26.
Wednesday was another day marked by hope. Stocks in Asia closed up nearly 2%. After the ECB announced interest rates would remain unchanged, markets remained un-phased despite the negative news. Later, the markets did retreat a bit to reality—but not for long. By the close, European equities had blasted upward to a 2.5% gain. The U.S. markets followed suit on this risk-on party lifting all boats. The 10-Year U.S. Treasury Bond rate, which was daily setting record lows last week, bolted up over 6% to end at 1.65.
The best explanation for this seems to be the old bad-news-is-good idea. Since the ECB held firm on rates, Europe is doomed. With Europe doomed, the central banks must do something to stop the bank runs. When they do their dirty deeds the stock markets will get their “fix” and the rally will be justified. In short, this is a phony rally on false hope.
Another theory was this rally occurred in reaction to the Scott Walker victory, implying a Romney victory, implying business-friendly government policy. That seems to me to be quite a stretch at this juncture. You would think after the Facebook fiasco, investors would wise up but apparently not. More likely, a single Wall Street Journal article by Jon Hilsenrath “Fed Considers More Action Amid New Recovery Doubts” provided the spark to ignite a rally. Fear went out the window with the VXO plummeting nearly 12% to close at 21.09, and the major indices broke back above their respective 200-day moving averages as they closed up nearly 2.5% on moderate volume.
Thursday, Asia closed up about 1% again following through from the surge in the west Wednesday. European stocks gained nearly 1% for the day as China reduced its interest rate by 0.25%. From the Fed-speak gone wild department, we had the pleasure of hearing from seven Federal Reserve presidents plus Tim Geithner.
Chairman Bernanke’s testimony before Joint Economic Committee of Congress carefully and repeatedly abstained from any new encouraging words for more monetary accommodation. This news deflated the sails of the hope-springs-eternal crowd a bit, knocking stocks back to a flat close in the U.S. on moderate volume. From prepared remarks Bernanke did give the obligatory statements (no news there) that the Federal Reserve stands ready to act if conditions warrant:
The Committee reviews the size and composition of its securities holdings regularly and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.
It was clear though from the question and answer session that followed that even when pressed, Dr. Bernanke would not indicate further QE was imminent or appropriate:
I recognize that rates are quite low so that clearly is a consideration….[10:31] Monetary policy is not a panecea. It would be much better to have a broad-based policy effort addressing a whole variety of issues….I would be much more comfortable if in fact Congress would take some of this burden from us and address these issues….there may be some diminishing returns [of QE] and that will be a consideration we would have to look at as we try to analyze what our options are. [10:42]
Near the close of U.S. stock markets, Reuters reported that the Fed released a proposal to increase bank capital requirements. After regaining a fair amount of ground over the past week, precious metals and miners dropped back about 3%. The fear index descended slightly, but AAII Investor Sentiment tilted from very bearish to a bit more so.
By the time the news of the day hit Asia Friday, all of the false hope had dissipated. As reality set in, Asian markets declined—ending down about 1%. Europe continued the trend. Rumors surfaced that Spain would ask for aid from the EU Saturday to halt the immediate crisis with its crumbling banks. U.S. stocks ended the day up 0.5% or so on hope and low volume.
For the week, stocks rose about 3.5%—most of which happened on Wednesday. Fear (VXO) deflated 24% to close at just over the critical 20 level. All of this hope lifted 10-Year U.S Treasury Bond rates about 7% for the week to close at 1.64%