October 18th, 2014
by Poly, Zentrader
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The equity markets are finally seeing action that has even the most hardened bulls running scared. In the past, I've been quick to dismiss selling periods - Cycle Lows - as natural regression-to-the-mean events. In a bull market, an oscillating Cycle pattern of two steps forward and one step back is what drives an asset higher. But this time is different...two steps back is completely out of character. So much so, that I now believe that the 3.5 years bull market is now in serious trouble.
If we were to look for reasons to explain the recent selling, there are plenty to be had. The most likely is not a specific piece of news or single data point, but that the collective herd of market participants is fickle and can be easily spooked. The current bull market has broken plenty of records, including the length of time - more than 3 years - since a 10% correction. This has resulted in double-digit market gains for consecutive years, and a near vertical rise over a sustained period of time. Against the backdrop of a soft world economy, this performance is nothing short of remarkable.
What are potentially playing out are the very beginnings of a market turn. We could soon experience an environment of reversing psychology, where all tidbits of news will be construed as negative for the markets. It takes a lot of confidence (and ignorance) to elevate and sustain a market at present levels, especially one built on blind faith and the idea that the FED can keep the market elevated into perpetuity. This has bred a level of speculation, and arrogance, often seen at the top of longer dated Cycles.
If we need a catalyst for a potential market sell-off, we need only look toward Europe. Although the EU is just one market in the inter-connected global economy, it still makes up almost 25% of world GDP. And it's large enough that any issues will send shock waves through world markets.
The EU's problems are structural in nature, with too much government red tape, inefficient and constrictive regulations, and a labor policy that is not consistent with a rapidly-changing world economy. In addition, EU leaders have made poor choices of late. In particular was the instance on excessive austerity at precisely the wrong time in the Business Cycle. Austerity is choking what little life remains in the European economy, and is consuming capital needed to support investment and growth initiatives. The time to pay down debts and reign in spending is during good times; doing so gives the flexibility to loosen the reins and deficit spend during bad times.
What's developing in Europe is a negative economic feedback loop comprised of declining sales, lower production, declining income and lower employment. This is compounded by a general lack of leadership across the continent, and a flawed, unworkable economic union. The northern countries have been somewhat sheltered up to this point, primarily because the single currency has been very advantageous to them versus the consumption-focused economies in the South. In addition, France has faltered recently and has now made it clear that it cannot adhere to a capped budget while the economy shrinks.
Even more concerning, while Germany has been the main benefactor of the Euro experiment, it too is now showing clear signs of tipping. German exports in August fell 5.8%, the biggest monthly decline since the 2009 recession. And this on the back of poor reports of German manufacturing orders and factory output. Europe's general economic malaise is threatening to become a full blown contagion.