Wednesday, 22 June 2011

Summary
As long as the S&P 500 stays above the 1,250 level, chart-technically a near-term rally to new highs remains possible. The market is oversold. That the Greek situation appears to become less tense could feed into the rally, yet it is unlikely to last long. In the medium term we expect stock prices to tumble (S&P 500 towards 1,100 and lower levels). The sweet spot of the past quarters a loose fiscal and monetary policy plus high economic growth in the emerging countries is dissipating. Central banks and governments are tightening their policies. As a result, the negative effects of the current balance sheet recession will come to the fore again. If so, it will be abundantly clear that stock prices have risen (far) above their real value.

Stock markets Sweet spot is fading

The pullback in stock prices since early May has now become strongly oversold. Investors are increasingly downbeat while several major stock indices are approaching important support levels. From a chart-technical perspective the drop could end at any moment. Subsequently, the markets could stage at least a substantial recovery (S&P 500 to 1,400). Such a recovery could go hand in hand with: A new financial aid package for Greece that does not trigger CDS payouts on Greek bonds (the latter would carry the risk of a negative chain reaction for financial institutions). Better economic data in the US and Europe as factors wear off that depressed growth earlier in 2011. For instance supply chain disruptions to imports from Japan, bad weather, and the (delayed) effect of the commodity price rally at the beginning of the year. The aforementioned technical indicators are no guarantee that prices will indeed rally sharply. So far volumes have been low on market rally days (a sign of weakness). In the past, sometimes steep drops occurred when the market was oversold. Should this happen again, a rally could still take place but probably not to (fractionally) new highs. A drop in the S&P 500 to well below 1,250 would suggest that the trend reversed from up to down in May.

Medium term outlook Whether this technical rally will start from the current level or even lower does not change our medium term outlook one bit. We think there is a high chance of additional drops. Research from Morgan Stanley and others shows that the current recovery is very weak compared to previous recessions and recovery periods in the past 50 years. Especially if we consider that: Normally, the recovery would be proportional to the gravity of the recession. As this has been the deepest recession since the Great Depression the recovery should have been exceptionally fierce as well. The recovery was boosted additionally by unprecedented fiscal and monetary impulses. Balance sheet recession Clearly the present recession is far from normal. It was not a reaction to monetary tightening measures curbing inflation, or a natural disaster. The root cause was high indebtedness. We are seeing a balance sheet recession; for it to end debts will need to be paid off. To what extent is unclear although earlier balance sheet recessions suggest that this could take years. During such a period of very low growth, fresh recessions could loom. In the recent past the fallout of the recession did not appear so bad but this was mainly because of the huge fiscal/monetary stimulus and the rise of the emerging markets (that did not have a debt problem and were benefiting from a very loose monetary policy in the West). In other words, stock prices ended up in a sweet spot on the back of the expansionary monetary policy and high growth in the developing industrial countries, where western multinationals are increasingly making a lot of profit. The process of debt reduction in the private sector is far from over. As long as property prices keep falling and household debts are above the long-term average, this deleveraging will continue. Most central banks are tightening their monetary policies and virtually all of the governments need to apply the fiscal brakes. In other words, the downward effects of deleveraging in the private sector will increasingly come to the fore. The predicament of the weak countries in Europe (that have been bailed out) shows that once public debt is excessive the state also starts to contribute to the balance sheet recession. Sweet spot melting away Currently stock prices are moving away from this sweet spot. As growth expectations continue to

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decline on fiscal and monetary tightening we foresee falling profit expectations. It will increasingly become clear that stock prices have risen far above their actual value. Eventually the S&P 500 could drop to 1,100-1,000. Continuous tensions in the eurozone and fears of a banking crisis will likely depress stock prices as well. If a new aid package for Greece is agreed upon (which we expect) this will again be a liquidity solution to a solvency problem. In other words, the underlying problems in Greece will remain. The same issues (excessive indebtedness and lagging competitiveness) will play up repeatedly and it will merely be a matter of time before Greece needs to go cap in hand all over again. The same applies to Portugal. Following the current downturn, we foresee another rally on the stock markets once mounting deflation fears force central banks into flooring the gas pedal yet again.

Chart-technical Analysis
S&P 500: In recent days the S&P 500 index rallied in reaction to the drop (to 1,265) in recent weeks. This brief rally phase may well have ended (at 1,295). We anticipate additional drops. Support near 1,260 and 1,246 continues to be important.

DAX: The short-term pressure in the DAX has become neutral yet the short-term cycle is pointing towards potential consolidation. Support at 6,994 has been tested by now. That the rally exceeded 7,150/7,200 is a positive signal. It underpins a scenario that sees the DAX bottoming out. Conversely, a drop to below 6,990 would be negative for the DAX in the near future.

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NIKKEI: The NIKKEI is still in a sideward pattern. However, signs are increasing that a minor rally may be in the offing. If the index drops below support at the 9,300 level, additional drops could occur in the near future. If so, support comes in around 9,200 and 9,000.

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