European Misery vs. U.S. Improvements - Will Europe Sink U.S. Markets?

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A 3,600 mile long rope from New York to Madrid, Spain would fittingly symbolize the tug of war between the United States and Europe.

Perched on one side of the Atlantic is the S&P 500 Index (SNP:^ GSPC), which is barely 15% below its 2007 all-time high and just saw record high corporate earnings.

Crumbling on the other side of the pond is Spain's IBEX 35, which trades more than 50% below its 2007 high. But Spain is not the only weak link in the chain. France's CAC 40 also trades 50% below its all-time high and even Germany's DAX is off by more than 20%.

Even the world wide MSCI EAFE Index (NYSEArca:EFA - News) is down some 40% since its 2007 high. The chart below compares the S&P (NYSEArca:SPY - News) with Spain's IBEX 35.

Such big disparities are unusual, so the key question is whether the U.S. market will lift up Europe or if Europe will drag down the U.S.

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U.S. Strength Is Also Its Weakness

Citing corporate earnings, market analysts believe that the U.S. economy is booming, although 46 million Americans on food stamps beg to differ.

Various accounting gimmicks - prevalent predominantly in the financial sector (NYSEArca:XLF - News), and an extremely accommodative Federal Reserve, have made corporations less reliant on consumer spending.

Nevertheless, let's assume that corporate earnings are for real, or at least as real as they were in 2000 and 2007. The chart below shows record earnings foreshadow market tops like falling leaves foreshadow winter.

                           

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Based on facts and historical patterns, record earnings are net negative for stocks. In hindsight, this was particularly pronounced in 2010 and 2011.

Even as the market sculpted the 2011 top, the April 3, 2011 ETF Profit Strategy update warned that: "A major market top is forming. S&P 1,369 - 1,382 is a strong candidate for a reversal." Fueled by better than expected earnings, the S&P briefly squirted to 1,371 and cratered 20% shortly thereafter.

A year earlier the April 16, 2010 ETF Profit Strategy Newsletter looked at the earnings picture and warned that: "The message conveyed by the composite bullishness is unmistakably bearish. The pieces are in place for a major decline." The Flash Crash happened 13 trading days later.

Strong earnings are an asset to the economy, but they are also one of the stock market's (NYSEArca:VTI - News) biggest liabilities. Even in sports, a streak can only last so long before it breaks. The 2012 earnings season is shaping up to be a repeat of recent years.

Europe - A Pattern of Failure

What comes to mind when you think of June 26, 2009? That's the date when Greece's Finance Minster announced a tiny budget deficit. This tiny deficit blossomed into the largest sovereign default in history.

Below is a small bouquet of headlines that illustrates the progression of Greece's situation:

December 21, 2009: "ECB member says no bailouts for Greece" - WSJ

January 18, 2010: "Two EU ministers: No bailout for Greece" - WSJ

April 24, 2010: "Greece asks for $60 billion bailout" - AP

May 3, 2010: "Greece gets $146 billion rescue package" - Reuters

December 17, 2010: "IMF approves $3.3 billion for Greece amid impressive fiscal adjustment" - Bloomberg

October 27, 2011: "The debt is absolutely sustainable now. Greece can settle its accounts from the past now, once and for all" - Greek Prime Minister

The Greek saga would be humorous if it wasn't so sad. What's the moral of the story?

We've learned that the European Central Bank (ECB) totally misjudged the scope of Greece's problems. We've learned that EU ministers had no clue. We've learned that Greece only needed to ask for $60 billion to get $146 billion. We've learned that the International Monetary Fund (IMF) considered Greece's fiscal adjustment in 2010 impressive and we've learned that a country in trouble will say anything to get more money. What reason do we have to think Spain, Portugal or Italy will be any different?

Based on a rough assessment, I would say Spain, Portugal and Italy are now about where Greece was two years ago. Instead of bailouts, they got low interest rate loans. Instead of hundreds of billions of euro in 2010, the ECB gave a trillion in 2011/12.

Spreading the Virus

Holders of Greek debt only lost about euro100 billion, so why did the ECB make over euro1 trillion long-term low interest loans available? The ECB obviously knows that the problem has spread beyond Greece.

The ECB is encouraging European banks via the low-interest LTRO I and LTRO II loans to buy the debt of fiscally morose countries like Spain, Italy, Portugal, etc. This keeps the bond yields low and debt manageable for those countries.

But what it doesn't do is quarantine the toxic virus like debt of Spain, Italy, Portugal, etc. Like any kind of epidemic, wouldn't it make sense to isolate and kill the problem before it spreads?

The amount of toxic government bonds in circulation is billions (possibly hundreds of billions of dollars) higher than it was when LTRO I started about six months ago. That means if Spain (or Italy, or Portugal, or...) goes bust, the damage will be much greater than it would have been six months ago.

If the pattern of Greece's "deny and defy" approach is any guidance, Spain and other fiscally lackadaisical will have the same fate. There's just one minor difference:

Spain and Italy together have an economy that's 11x larger than Greece. You don't want to be invested when that bomb goes off.

The ETF Profit Strategy Newsletter's goal today - as in 2010 and 2011 - is to issue the kind of warning that gets investors out of stocks before the next leg down. When stocks fall, they tend to fall hard, and an ounce of prevention is worth more than a pound of cure (the Newsletter issued a sell signal at S&P 1,386).



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