For Monday, December 19, the market forecast is uncertain

We recommend selling your equity positions and holding cash, or otherwise moving to a risk-off position.  Avoid money market funds as a cash alternative due to exposure to European sovereign default risk.

Technical Comment:

The S&P 500 moved up a slight 0.32% on Friday, coincidently matching the index increase from Thursday.  Unlike Thursday, Friday’s move up was on much stronger volume, well above both Thursday’s volume and the 30-day moving average.  If the S&P closes up on Monday by about 5 points (0.5%), our forecast could return to growth.

Subjective Comment:

The large volume on Friday in the S&P 500 is notable to be sure, but the index value only crept up a small fraction.  A large move in the index combined with strong volume is the type of action indicative of strength.  The developing pattern of market weakness is still present, but the slight upward motion on both Thursday and Friday was enough to delay its complete formation.  It is not clear from the market data which direction the S&P 500 will proceed on Monday.

Two days ago we outlined a thesis from Robert Wenzel at EconomicPolicyJournal.com.  The short version is that the European Central Bank will be providing very cheap loans to European banks and accepting the lower grade bonds of the over indebted European nations as collateral.  Since the EU treaty prevents the ECB from purchasing sovereign bonds, this is a backdoor mechanism the ECB can implement to incent European banks to fund the ongoing bond purchases (bailouts) of these countries (Portugal, Ireland, Italy, Greece, Spain and others).  The rest of Mr. Wenzel’s scenario is the ECB will eventually be forced to do this by printing new money as they will eventually run out of higher quality assets to sell (sterilization), resulting in an inflationary bubble-boom in Eurozone economies and stock markets.  Friday The Economist published an article outlining the same backdoor funding observation.  They opened their brief article as follows:

AT THE European Central Bank’s last meeting, Mario Draghi did not announce any plans to scale up purchases of sovereign debt and, indeed, he indicated that previous statements interpreted as a promise to do so were in fact no such thing. He did, on the other hand, announce new measures to boost liquidity across euro-zone banking systems, including a facility through which banks can borrow unlimited amounts from the ECB, very cheaply, for up to three years. It quickly dawned on observers that banks might just use this borrowing to fund purchases of government debt, thereby addressing the crunch in sovereign debt markets.

As more market participants become aware of this backdoor ECB mechanism to bailout European countries, there will be more interest in watching bond auctions for signs this is actually occurring.  More astute observers will watch the ECB balance sheet to see if sterilization continues or if monetization has ramped up (aka money printing).  There have been so many attempts to “solve” the Eurozone debt crisis that we think market participants will watch closely for evidence this backdoor mechanism is working.  We think this means the markets will not rally, at least not for a little while.  Should this backdoor mechanism continue to bailout Europe, the question is will it be enough to stimulate a bubble-boom or just enough to avoid bankruptcies?  The ECB balance sheet must rapidly expand by large amounts in order to ignite a boom.

The situation in the US is different but dependent on Europe.  US banks have over $1.5 Trillion Dollars of excess reserves.  At the same time it has been estimated US banks have over $1.0 Trillion Dollars of exposure to European debt in German and French banks.  US banks, via fractional reserve lending, expanded the US M2 (seasonally adjusted) money supply by $470 Billion during 9 weeks this past summer (6/6/11 – 8/8/11).  This massive and rapid burst represented an annualized growth rate of 33% and provided the funding necessary for the sparks of life now appearing in economic statistics.  Prior to that burst, M2 had been growing a little over 5% for a full year.  Since 8/8/11 the M2 average growth rate crashed back down to 4.5% for the past 17 weeks where only $138 Billion was added to M2.  We think US banks initiated rapid lending during June and July, only to put on the breaks when the Eurozone debt crisis appeared to get worse.  They responded by hoarding their excess reserves as a contingency against their potential losses.  If US banks determine the ECB backdoor lending will prevent a Eurozone collapse, they could resume lending at the rapid rate seen last summer.  If they choose to resume aggressive lending, they can do so quickly and cause US markets to respond much faster than European stocks.  This is why it is necessary to keep a close watch on US money supply and bank reserve statistics as well as the ECB money supply and European bond purchases.  The ECB backdoor lending mechanism has the potential to mitigate the Eurozone debt crisis, which in turn could ignite US bank lending and fuel another manipulated bubble-boom in the US economy and stock markets.

If things turn around quickly, you will want to be in a position to move your investment funds back into US equities.  We’re still concerned about the Eurozone and advise against having cash in money market accounts.  The ECB backdoor mechanism will likely work, but there could be miscues along the way along with resulting market volatility.  If things turn, we think US markets could respond quickly.  Since this past June US M2 expanded over a Half Trillion Dollars, and US banks have plenty more to lend and appear able to do so at a rate of over $52 Billion per week.  If you have the ability to move quickly you’ll be able to take advantage of the up-turn that could result.

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