Waiting For the Other Shoe to Drop…

The contrast between the collapse in global stock markets in August and their relentless rise since the start of 2012 is positively eerie. The S&P 500 has risen nine times out of 14 trading days, and is on track to have its best January since 1997. The collapse of the VIX — the “fear index” — from a high of 48 on Aug. 8 to 18.67 at the close yesterday is even more disorienting.

The market’s schizophrenia worries me. Last year was one of the most volatile years on record for U.S. markets. The S&P 500 swung around an average of 1.3% a day between April and December, more than twice its 50-year average of 0.6% before 2008. August was a month for the record books with daily swings in the S&P 500 averaging 2.2%. The Dow Jones Industrial Average swung back and forth 400 points four days in a row for the first time ever.

Yet, much of the world’s smart money is equally skeptical. Octogenarian Joseph Granville, who has been publishing the Granville Market Letter for about 50 years, agrees the Dow will drop toward 8,000 this year. While I am not as pessimistic, markets have not been this overbought for the last five years, according to the measures that I use. Only the market’s run in the summer of 2010 even comes close. To add to the worry, the market’s recent run happened on spectacularly low volume, with trading on the New York Stock Exchange tumbling to its lowest level since 1999.

Genuine Good News… Or Just “Crisis Fatigue?”

On the one hand, the drumbeat of good economic news from the United States is improving. Sales of previously owned U.S. homes rose in December to the highest level since January 2011. Claims for U.S. jobless benefits fell to the lowest level in almost four years. The U.S. economy is projected to grow 2.3% this year. It may be that after being burned so many times, investors are simply immune to good news. The market is climbing the proverbial “wall of worry.”

On the other hand, it’s as if the market is playing ostrich by sticking its head in the ground and ignoring the bad news. Put another way, when the boy has cried wolf so many times, investors just stop listening. But the reality is, the threats to global markets have not gone away. And it won’t take much for sentiment to turn sharply.

Here are just a few issues that could derail the current rally.

1) A Potential Hard Default by Greece.

A month ago, the U.S. market was held hostage to the latest news from Greece. Yet recently, the U.S. market has either ignored or has been remarkably sanguine about its prospects. This reaction has occurred despite investors’ repeated rejection of Greece’s proposed write-down of 65-70% on current Greek bonds’ long-term value. In the meantime, the share price of the National Bank of Greece (NBG) — a recommendation in my Bull Market Alert trading service — has soared by 36.4% so far in January. That rise makes me look good. But it also leaves me scratching my head. After all, the fundamentals of Greece haven’t changed a bit.

2) The Sovereign Debt Crisis in Europe

Standard & Poor’s downgraded nine (!) European countries on Jan. 13 — also Friday the 13th. Germany remained the only major European economy to maintain its “AAA” rating. But instead of selling off, the MSCI EMU Stock Index has soared 7.53% since then. And the Bank of Ireland (IRE) — another “swing for the fences” recommendation in Bull Market Alert, has soared 46% since the start of the year. Even the beleaguered euro — which many commentators predicted had “10 days to live” back in December — has bounced sharply. It almost is if investors are too bored with the latest initiatives of Germany’s Merkel and France’s Sarkozy to care anymore.

3) Crisis in the Strait of Hormuz

Yesterday, the European Union (EU) decided to embargo Iranian oil exports, as well as freeze some assets of the Iranian central bank. The intention was to curb activities that might support Iran’s nuclear program. Oil prices quickly soared above $110 a barrel. Under normal circumstances, headlines about an “oil price spike” and “Middle East crisis” would have Wall Street traders glued to their screens. Today, few seem to care.

4) The Coming Hard Landing in China

In my view, the coming collapse of the Chinese economy is the biggest, yet most underrated threat to the global economy. Once the size of bad debts in the Chinese economy becomes evident, and demand for commodities collapses, China will be taking a big chunk of Asia, as well as resource-based Australia and Brazil, down with it. Throw in the inevitable political instability that will ensue when the Chinese take to the streets, and you have the makings of a serious global crisis.

These challenges form just a partial list and, by definition, do not include some unpredictable “Black Swan Event.”

So, yes, with an overbought market, low volume, and plenty of potentially bad news waiting in the wings, I am waiting for the other shoe to drop.

I’m just hoping that it won’t drop too hard.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru