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 May 14, 2012 09:14 AM

(By Cam Hui) Last week, I wrote to expect a short-term rally, which was a tactical trading call (see The "Merde" rally?) but I wasn't convinced that any rally would be the start of an intermediate term move upward for stocks:
My inner trader wants to buy risk in anticipation of an oversold rally. My inner investor tells me to watch the market action in likely ensuing rally to gauge the strength of the bulls as this is just another phase in the choppy up-and-down market action that we have been witnessing in the past few weeks.
The market action on Thursday and Friday makes me more unconvinced that this is the start of either a sustained bull or bear move. We have a lot of macro cross-currents between now and year-end and navigating them will be a challenge for any investor. In some cases, we have economies that appear to be outperforming but likely to start to underperform later in the year. In other cases, you have the reverse - economies burdened with negative news but whose headlines are likely to improve later. The difficulty is that the timing of all these twists and turns will be highly uncertain. Moreover, it is unclear which headline the markets will focus on during this period of uncertainty.

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To summarize my outlook, I use my framework of the Three Axis of Growth, namely Europe, China and the United States. I preface my analysis with the comment that, as an investor, I am agnostic on the question of whether an economic policy is the correct one or not. Rather, I focus on the likely effects of that policy on the markets:

  • Europe: News flow and headlines are negative and likely to get more negative. However, investors shouldn't discount the effect of a political response, which would serve to kick the can down the road yet one more time and the markets would rally in relief.
  • China: Uncertainty reigns, but the market perception of the likelihood of a hard landing is receding, at least for now. The change in leadership later this year is likely to usher in a period of stimulus, which would provide a bullish impetus to the markets.
  • US: American equities remain the global leadership, for now, but economic momentum is faltering and the Fed may not have the political capital to act between now and the November elections. Moreover, the US faces a fiscal cliff in 2013. Markets typically look ahead six months or more. When does the markets start to discount the negative effects of that fiscal cliff?

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Another European summer of discontent

) After the positive news about a "fiscal compact" and LTRO, which saved the eurozone from disaster late last year, the headlines from Europe is starting a negative cycle. The equity markets are reflecting that heightened anxiety as a glance at the DJ Euro STOXX 50 shows that it is in a well-defined downtrend. The bad news for investors is that the negative news isn't so bad that we are poised for a rebound. I would wait until the index declined into the support zone before nibbling away at positions.

Across the English Channel, the FTSE 100 is declined and is now testing the 200-day moving average. I interpret this as another sign of market stress over the eurozone.

Jeff Miller of A Dash of Insight put some perspective on why you shouldn't blindly react to the headlines and panic over Europe (emphasis added):

Most of the commentary we see has three steps:
1. Some problem in Europe(/p>)(

) 2. Cockroach/contagion/domino(/p>)(

) 3. Disaster for the world(/p>)(

) (/p>)(

) This type of commentary ignores any policy reaction, and also often insults the leadership of European nations, the IMF, and the ECB.(/p>)(

) (/p>)(

) (snip)(/p>)(

) I suggest that investors read very critically when a story suggests causal relationships that lack specificity or quantification. Be even more suspicious when the story ignores policy responses. And finally, how about some quantification concerning Europe's impact on the US economy? (/p>)(

) (/p>)(

) My own conclusion -- familiar to regular readers -- is that theEuropean story is an ongoing process of bargaining and compromise. US observers are far too ready to impose their own value judgments on other countries and cultures. The exact trade off of austerity, bank recapitalization, central bank intervention, and rescue funds is a work in progress. The exact nature will change and I still expect new entrants.

Marc Chandler at Brown Brothers Harriman wrote an excellent piece entitled 10 points on the comity of Europe that made a similar point. The article is well worth reading in its entirety, but here are some highlights:
1. EMU itself is a culmination of two trends: 1) the integration of western Europe since the 1950s and 2) efforts to keep Germany wedded to the fortunes of Europe. The elite, and it is an elite project, knows no alternative strategy.(/p>)(

) (/p>)(

) (/p>)(

) 2. Because there is no Plan B, there is no mechanism to formally eject Greece or any other member. Polls indicate a majority of Greeks want to stay in EMU.(/p>)(

) (/p>)(

) 5. EMU is an institutional expression of the comity of Europe. These nation states have lived with each other for longer than the US has been around. It is very much like a family, even if dysfunctional (what family isn't?). They did not get to chose each other. Their histories are intertwined. There is a great desire for peace and prosperity. It is difficult to prove that integration has made peace on the continent, but is sure looks that way.

Miller and Chandler make the point that the European elites will find a way to defuse the crisis, because of the long history of Europe and the political commitment involved. Already, the consensus is starting to shift:


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