Over the past two weeks even more evidence has emerged that the "sweet spot" the market has been enjoying in the last few months is coming to an end. (See "The Market Sweet Spot Is Ending", March 29, 2012). The European sovereign debt problem has emerged in the headlines once again, more key economic indicators have fallen short of expectations and the S&P 500 dipped below its 50-day moving average for the first time since December.
The market started to decline from its peak level when the latest FOMC minutes hinted that an imminent implementation of QE3 was not on the table. The problem is that there was always an inherent contradiction between celebrating the advent of a sustainable recovery, while, at the same time, expecting the initiation QE3. This didn't make much sense. If the U.S. economy were truly in a sustainable recovery QE3 would not be necessary. In itself, the hope for a new quantitative easing program indicated that investors really believed, as we did, that the economic recovery was almost completely dependent on massive doses of liquidity, and incapable of going forward on its own.
We pointed out at the time that economic expectations had become so optimistic that a number of key indicators started to disappoint. These included core durable goods orders, the Richmond Fed Manufacturing Survey, the Chicago Fed National Activity Index, initial weekly unemployment claims, pending home sales, new home sales and existing home sales. Since then, other indicators that have fallen short include payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index and personal income.
The U.S. economy has also benefitted from the inability of seasonal adjustment factors to account for an unusually warm winter and the distortions introduced by the fact that the worst of the 2008-2009 recession occurred in about the same months. Since this made the economy appear to be much stronger than it actually was, the payback is likely over the next few months.
The economy is also facing the now well-known "fiscal cliff" beginning in January 2013. This includes expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits, the highway bill, the farm bill, and the sequester established in last summer's debt limit agreement. Various estimates have indicated that the hit to GDP can be as high as 4%.
The European sovereign debt crisis also entered a "sweet spot" following the start of the ECB's Long Term Repurchase Operation (LTRO) and the Eurozone settlement with Greece that stopped the immediate liquidity crisis and took it out of the headlines without actually curing the insolvency issue. The LTRO provided about 1 trillion Euros to bail out troubled European banks in return for the debtor nations' promise of austerity. However, the continued worsening of the economic outlook in the EU's debtor economies has once again led to soaring bond interest rates, particularly in Spain.
The problem is that austerity in the weaker nations causes their economies to decline even more, leading to greater budget deficits and the need for even more bailouts. It also tends to cause internal dissention and increase the popularity of political parties that would attempt to abandon or substantially reduce the austerity program. That makes it highly unlikely that the stronger nations would continue their liquidity programs to the detriment of their own taxpayers. The EU has now been "kicking this can down the road" for more than two years and appears to be running out of road.
The market has now shown significant signs that momentum is waning. The S&P 500 fell below its 50-day moving average for the first time since December, although it slightly climbed back over it today. After a big run to the upside, investors who missed the rally often attempt to use the first sign of weakness to get aboard, and this is what is probably happening now. In our view, this is just a temporary bounce that will fail and make new lows. We believe that the downside risk is substantial.