A Brief Pause or the End for Equities?

 A Brief Pause or the End for Equities?

All financial assets move in long wave cycles from undervalued to overvalued and back again, but whilst the duration of these cycles varies across these asset groups, irrespective of whether it is commodities, equities , bonds or real estate, they all move in a similar way. During the movement from undervalued to overvalues, prices rise in a long term 'bull market', punctuated by severe corrections or counter-trend moves along the way. Once the over valuation has reached an extreme, the market reverses, and enters a 'bear market' where prices once again start their long descent.

We can see this illustrated in the chart below.

 

 During the 'bull market' phase, as prices rise and the fear of the preceding 'bear market' is forgotten, investors emotions slowly move from depression through hope, optimism and exitement  to reach their final state of euphoria and greed.

However, whilst this journey might seem simple, due to these counter-trend moves the reality is very different. Whenever investors become too bullish, too confident and too convinced that a trend is in place, a correction will take place that will shake their beliefs and re-introduce a touch of fear into their lives, Is the bull market over? Will prices continue to fall? The bull market will shake some investors off its back and then continue onwards and upwards until investors once again get too bullish. This is why it is so important to monitor things like the Committment of Traders (COT) reports, as they can give great insight into the level of bullishness in a market give indications as to when a counter-trend move might begin.

We can see how these counter-trend moves have impacted the S&P 500 Index since the start of the current cyclical bull market in 2009.

These corrections are normally fast and furious, exactly the kind of conditions needed to inspire fear amongst investors, and during the month of August we have seen counter-trend moves in a number of markets, among them Equity markets, the US dollar and Gold. In the next chart of the S&P 500 Index I have extended the data to include the entire move since the 2009 lows and we can see how long it has been since a serious correction took hold, it was clearly long overdue.

Because of the severity of the latest correction, especially last weeks volatility, investors have once again begun to question whether the bull market is over. The answer is possibly, but I doubt it. Bull markets finish when the public get sucked in due to the constantly rising prices. This stampede of investors leads to spectacular price rises and a 'blow-off' phase, typified by 'this time is different' thinking and to coin a phrase from Alan Greenspan, 'irrational exuberance' (see chart below). Thus far we have not witnessed this, and allied to my belief that as the global economy unfolds money will flow into US Equities as a safe haven leads me to believe that equities will recover and go to new highs.

However, just because the market should rally to new highs doesn't mean it can't have a bigger correction now. If we look at the Point & Figure chart of the S&P Index below we can see that the rally from last weeks low at 1870 has paused at overhead resistance in the 1990 area. 

 The market is now at a critical juncture where either the panic will subside and prices will continue to grind higher, or the market will roll over again and test the lows. Should the sell-off resume, the 1870 low will provide the first point of support, followed by 1830 and 1740. It is also worth noting the bearish price objective of 1621, and although price counts tend to be more accurate when they occur in the direction of the major trend (which in the case of the S&P is up) we should not just disregard it.

  Having waited so long for a correction to materialize, it is unlikely to be over so soon, and the probability is that there is more volatility ahead. Should we retest the lows and go lower, keep your eyes on the support levels and the 'talking heads' on TV. 

When they start saying that the bull market is over, it's time to buy!

The Greek Euro Death Roll

The Greek Euro Death Roll

Like a poor story line from a soap opera, the Greek euro saga seems to have been playing out for years. On a number of occasions the warning signals have flashed amongst talk of imminent defaults, Greek economic collapse and the resultant chaos in the Eurozone, only for some political agreement to be cobbled together and the endgame kicked further down the road.

The crisis started for Greece back in 2009, badly affected by the fallout from the GFC, Greece struggled to pay back its sizeable debts. Concerned by the possibility of a Greek default, international investors stopped buying any more government debt, cutting off the usual funding stream and forcing the government to borrow yet more money from the EU and the IMF. This borrowing in turn also needed repaying with interest, and as the repayment dates loomed more borrowing was needed to fund the repayments from these previous loans, the downward spiral was set and Greece and the Eurozone became locked in a financial death roll. 

Over the years since 2009 the effects on the Greek people have been profound. Part of the terms of the initial bailout was that Greece implement a policy of severe austerity in order to get their borrowing under control. This has resulted in economic hardship, civil unrest and political turmoil as successive governments have been caught between the demands of the eurozone on one hand and the people's resistance to austerity on the other. It must be remembered of course that the Greeks have hardly been innocents in their own demise, with decades of rampant corruption, endemic tax evasion and financial mismanagement laying the foundations of disaster long ago, however it is the actions of the European Union and the IMF, more interested in their own preservation than in the welbeing of Greece that has compounded the problem.

The EU is determined to keep Greece inside the monetary union. It cannot allow the Greeks to default on its debts whatever the cost to the Greek people, as a Greek default would open the door for Portugal, Spain, Italy and a host of other countries to renege on their debts and the entire Euro experiment would die. However in spite of using increasingly large carrots and sticks in order to force the Greeks into compliance, the Greek people are becoming increasingly vocal in their opposition to the restrictions imposed upon them, and it is my belief that if not the current government,ultimately they will elect a government that will take them out of Europe whatever the cost. 

One of the ways we can see how the financial markets interpret the risks to the eurozone from a Greek default is through the currency. As a general rule, the more confidence international investors have in a country or economic zone, the more money they will move into that currency in order to invest in its bonds, equities, property etc. Conversely, as confidence wanes, these assets are sold and the money is then moved out of the currency into something with a better return, like US Dollars for example. The movement of the currency acts as a barometer, enabling us to interpret what the future might hold.

Here we can see a chart of the Euro relative to the US Dollar.

It shows us the high in the Euro prior to the GFC and the subsequent multi year trading range ending with a break below the 119/120 support in December of last year. Subsequently it dropped like a brick until finding some support in March, since when it has managed to stage a recovery. We can see from the oversold readings on the RSI indicator at the bottom of the chart that the price collapse from the 139 level was extreme and that a rally was overdue, however longer term the price move has done serious damage to the outlook for the Euro, something we can better see with the next chart.

Here we have a Long Term Point & Figure Chart of the Euro.

I have talked in previous posts about the predictive powers of a P&F chart and that whilst it isn't infallible, it can be incredibly accurate. Here we see the entire history of the Euro currency and it is clear that the breaching of the 119 level has triggered a downside count of 71.32. This is an incredible target and suggests a virtual implosion of the eurozone in its current form.

We know that since March the Euro has rallied from very oversold conditions and the next chart gives us a shorter term perspective to help gauge how much longer the rally might continue.

Here we have a shorter term P&F Chart of the Euro showing that the rally target of 113.24 from the March low has already been met, and that there is likely to be resistance around the 115 level. We also know that should 115 be broken and the rally continue, the old support level of 119/120 would provide serious overhead resistance.

When we look at these charts collectively they seem to indicate that whilst there is the potential for a further Euro rally in the short term, the medium to long term outlook is extremely negative. Although the downside count of 71.32 is extreme, when we consider the cascading effect from a Greek debt default it is not hard to imagine such a scenario and the implications of such a move would indeed be catastrophic for many people and businesses, it might well pay to consider what alternatives you might have should you be holding Euro denominated assets.

It must be stressed that the move is highly unlikely to occur in a straight line, there will be falls and rallies however the potential for a panic move cannot be ruled out, especially when the Greek domino finally falls.

Whenever Greece ultimately defaults it will lead to years of economic hardship for its citizens, however it is what it portends for the rest of Europe that is really worrying