The current rally in stocks is
relatively simple to explain. Hedge funds and institutional managers believe
the Europeans are on the verge of a significant debt crisis breakthrough. If
that is the case, a twenty-seven month bearish drag on the market is about to
be removed. If a twenty-seven month drag is about to be removed, it stands to
reason stocks could continue to push higher in the coming months.
If you are looking for concrete proof
of a shift toward "risk-on", the chart below of Spanish yields is an
excellent place to start. Falling bond yields are indicative of an increasing
confidence in Spain's ability to repay their creditors, which is the main
concern in a debt crisis.
In the chart below, points A, B, and
C clearly illustrate the market's number one concern over the past
twenty-seven months...Europe. Notice how market peaks coincided with bad news
from Europe. The reduction in fear, shown via boxes D and E, tells us the
market's (SPY) number one burden seems to be getting lighter.
The European debt crisis moved to the
top of the market's worry list on April 23, 2010 when Greek Prime Minister
George Papandreou called for a eurozone-IMF rescue
package following a steep rise in borrowing costs (see point A in chart
above). Some better than expected economic data and QE2 pushed stocks toward
point B in 2011, only to be derailed by a European commission report stating
Greece's budget deficit was worse than expected. With the markets extremely
vulnerable in late 2011, the European Central Bank stopped the bleeding with
unlimited three-year loans for banks. The green box labeled D above shows the
S&P 500 making a higher low relative to the 2010 low, which marked a
turning point in the minds of investors. The European "derail theme"
returned near point C when Spanish bond yields began to rise sharply. Talk of
more intervention from the ECB allowed stocks to put in a much higher low
above box E; higher lows illustrate decreasing concerns about Europe.
On the technical front, numerous
European stock markets have a potentially bullish set-up known as an inverted
head-and-shoulders pattern. In the chart of Spanish stocks (EWP) below, the
small size of the right shoulder relative to the left shoulder shows a
significant reduction in the fear of an implosion in Europe. Similar bullish
set-ups are in place for German (EWG) and Italian stocks (EWI).
Bullish set-ups and signals similar
to early melt-up periods in 2009, 2010, and 2011 are covered in the video
below for the S&P 500 (00:50 mark), utilities (XLU) relative to stocks
(01:30), NYSE Composite (03:15), stocks relative to bonds (06:01), tech
stocks (QQQ) relative to S&P 500 (07:37), RSP (08:57), EWG Germany
(11:01), EWP Spain (11:01), VEU (12:38), NASDAQ (14:46), Dow (15:09), IWM
small caps (15:29), MDY mid-caps (15:47), XLB materials (16:04),
transportation stocks (16:34), GLD gold (17:06), SLV silver (17:42), TBT short
bonds (17:51), and Russell 2000 (20:32).
The major stock exchange in London
also reflects increasing optimism about the ECB's bond market intervention
As we noted on July
2, Germany's increasing acceptance of additional bond market intervention
from the European Central Bank is a watershed moment in the twenty-seven
month crisis. We have been open to better than expected outcomes since late
May, and we continue to believe a "monster"
rally could occur in the coming months. A few hurdles
remain in Europe, which means a market pullback remains possible. As long
as the ECB is making progress on the bond buying front and the charts point
to favorable outcomes, we will remain positioned for a risk-on environment.