Spring Break.

April 17, 2012

Stocks imploded like Jon Corzine's reputation last week, reacting negatively to weak March employment data and renewed fears in Europe.
After racing out to a 12% first-quarter gain, the S&P 500 packed its bags and took the family south, having fallen 2.7% since April began. Yet, unlike Kim Kardashian's wedding vows, markets have a reason for their abrupt change in sentiment.
In January, the fear was palpable. Risk was oversold as investors shivered at the prospects of Europe's implosion and an American recession. By April, investors had relaxed. Fear over European debt issues appeared to have been quelled. The U.S. seemed to be effectively navigating its economic maladies. The VIX index, which measures market volatility, had dropped to levels indicating that investor concerns had flat lined.
So what gives?
In short, we believe that investor confidence is realigning with the dangers that continue to threaten global economic and corporate earnings growth.
Investors are frequently lulled into a state often occupied by J Lo on American Idol--completely oblivious to what is occurring around them. Now, investors are being reacquainted and coming to grips with the very real problems that left the front pages, yet never disappeared completely, only a few months ago.
Iran and the Cost of Oil
Global energy prices continue to rise as geopolitical spectators consider an Israeli attack on Iran's nuclear infrastructure. Analysts agree that the window is closing on the West's opportunity to prevent Iran from going nuclear. Iran contends that its nuclear ambitions are peaceful, and as legitimate any nation's right to develop nuclear energy sources.
As the saber rattling continues, the fear is that Israel could strike at any time. At that point, Iran's probable reaction would be to mine and shut down the Strait of Hormuz, which connects the Persian Gulf to the Arabian Sea, and through which 20% of the world's oil passes.
The strait is absolutely critical to the world economy. Should it be closed, oil costs and energy prices will spike. The fear is that this will kill an already tenuous global economic recovery.
China's Growing Pains
There is no doubt that China's economy has slowed. The question is, how much?
The world's second largest economy expanded at its slowest pace in three years last quarter, growing at 8.1%. Last year saw the Chinese economy expand by 9.2%.
While many economists feel the slowdown is a natural deceleration, the ramifications of a Chinese hard landing are vast. China is a key market for most of its Asian neighbors. If China begins buying fewer imported goods, their economies take a hit.
Further, China's ravenous hunger for the natural resources and commodities needed to fuel its infrastructure development has been a key contributor to the economic well being of many other nations. Should that slow, or worse--contract dramatically, the ripples will be felt throughout the global economy.
A Farewell to Easing
The Fed has recently disappointed markets by explaining that the strength of the U.S. recovery likely means an end of quantitative easing (QE). This is significant, because the stock market loves QE like Star Jones loves air time. QE puts cash into the system. That cash needs a place to go. It often ends up in the stock of publicly traded companies.
QE (cash injections), low interest rates (easy money) and low inflation (predictable purchasing power) represent a powerful cocktail of stimulants capable of sending even average stock markets higher. In fact, we would argue that these are the three most powerful variables necessary to any upward trending market--outside of improved earnings.
So, when the Fed says that it will no longer engage in easing activities, the market reacts like Andy Dick in rehab. Not pretty.
The Pain in Spain
Considering all of the usual suspects in the European debt drama, Spain is the new Kaiser Sohze.
Yields on Spanish bonds have been spiking. Credit default swaps on the bonds of American banks having exposure to Spain have jumped. This means that the market believes there is an increasing opportunity that the Spanish economy (and its banks) may collapse.
Spain is already enduring a severe recession, and will likely require a bailout by the European Central Bank this summer. The Spanish stock market is down 10.8% this month alone. That is ominous, as the stock market is generally a leading economic indicator.
Worse, Spain was one of the main beneficiaries of the recent European Long-Term Repo Operation, and yet it is still coming apart. Why? Because the values of Spanish sovereign bonds are declining quickly, crushing the balance sheets of the Spanish banks. So, in addition to the nation's fiscal crisis, you now have a potential banking crisis.
All of this ends up looking like another Greek-style bailout, accompanied by another decimation of private creditors. All at a time when Europe can ill afford any financial setbacks.
What's Next?
So, should investors panic, sell and hide? Course not. Haven't we seen this movie before?
There are reasons for optimism. The market is much oversold. A snapback could be in order
Also, as the U.S. labor market is struggling, some analysts are forecasting a change in the Fed's opinions, and a renewal of quantitative easing this summer.
Finally, last week brought the beginning of Q1 earnings season. And the initial reports from major companies were largely positive, with 75% of the larger companies that reported beating estimates.
Bottom line? Most of the nation has been on Spring Break these last couple of weeks. The stock market, having raced out to a strong first-quarter return, could simply be taking a breather as well. Equities could come back invigorated following a brief respite. This week's earning will tell the tale.
Yet, stocks could return from Spring Break like so many frat boys after a week in Daytona--sick, exhausted and in need of another vacation. If that is the case, then this market will quickly resemble last year's initial performance. A fast start followed by downgrades, sovereign debt woes and lots of turbulence.
Time will expose this market for what it is. Stay tuned...

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