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Friday, March 09, 2012

Europe on the Defensive

Kirk to Scotty: "What's the damage report, Mr. Scott?"

Scotty to Kirk: "Our defense shields are down after the last hit, Captain...and I don't know how long it will take to repair them...awaiting your orders, Sir..."

Kirk to Scotty: "Blah, blah, blah, blah, blah, blah, blah...yada, yada, yada!"

FAST FORWARD FROM THE 60's STAR TREK ERA TO FRIDAY'S GREEK CREDIT DEFAULT SWAP EVENT...and substitute "Kirk" with "Merkozy" and "Scotty" with "Draghi"...the words and message don't change...and, well, you get the picture.

With the problems of the entire EU's fiscal disharmony occupying Europe's time and attention as it endeavours to force austerity measures on EU members, it is difficult to imagine that any of these countries will grow their economy by any significant amount over the next year(s)...witness the poor numbers coming out of Europe and Germany relative to German Factory Orders, Europe's 2011 Q4 GDP, Europe's Unemployment Rate, and German Industrial Production, to name a few, since February.

As shown on the Daily charts below, the European Financials ETF (EUFN) and the EUR/USD forex pair did not participate in Friday's (albeit relatively subdued) rally  enjoyed by Germany and France...nor did Italy and Spain, as shown on the table below...Italy, in particular, was hard-hit.

As can be seen on the two ratio charts below of the DAX:EUFN and DAX:XEU, the EUFN and the Euro are producing a drag on Germany's Stock Market Index. Any meaningful and sustainable advance from this point in the DAX will need to see a resolution of this negative effect.

No doubt, the EU will face many more time-consuming problems over the coming months, which will require analysis and the deployment of damage control measures to mitigate any further negative impacts to its already-weakened growth prospects, and to attempt to attract foreign investment. This puts Europe's markets in a defensive mode as opposed to a robust, growth-oriented position. One of the issues facing Europe has been rising unemployment since 2008, in spite of the ECB's LTRO 1...we'll see if LTRO 2 makes any difference in due course.

That being said, longer-term investors may focus their attention on the U.S. markets, which are subject to less negative impacts from the Federal Government's fiscal disharmony and are under the protective umbrella of the Fed.

It has long been my view that in order for the U.S. equity markets to rally, the financial markets must also be on board. As a confirmation that any further advance in the equity markets is sustainable and supportable from this point, the financial markets will need to gather strength and participate in such a rally. I'd look for increasing and, more importantly, sustained higher volumes in both the equity markets and the financial markets over the next weeks/months as a confirmation of investor trust.

As can be seen on the two ratio charts below of the SPX:XLF and SPX:US$, the XLF (Financials ETF), in particular, is producing a drag on the S&P 500 Index. Any meaningful advance from this point on the SPX will need to see a resolution of this negative effect...there is a considerable headwind facing XLF at the moment. It will also be interesting to see whether money continues to flow into the U.S. $ should the SPX continue to rally.

Further to my post of February 28th, the ratio chart below of the SPX:VIX shows that the S&P 500 Index is at a major volatility resistance level and is faced with negative divergences on the RSI, MACD, and Stochastics indicators. This will bear a close watch to see if a short-term pullback is in order for the SPX, or whether a breakout  with confidence occurs (with the financials fully on board), sending the VIX further into complacency territory, and reversing these negative divergences.

Two events that the markets will, no doubt, be affected by for the coming week are the Fed meeting on March 13th (close attention will be paid to the Fed's "language" for any hint of further monetary easing programs that may be employed) and Quadruple Witching Options Expiry Friday on March 16th.