Stocks Still In A Danger Zone

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With a week to go, the equity market is facing severe losses for the third quarter. The S&P 500 is down 13.5% quarter-to-date and a negative 8.2% so far in 2011. Today’s fractional increase was a calming respite to a week that saw the index reduced by 6.5%. Wednesday and Thursday alone saw a combined loss of 6%, one of the most destructive two-day periods in years.

It would be nice if today’s calm were a forecast of the weeks and months ahead, but that is highly unlikely. Political tensions are extremely high in this country at a time when cooperation is necessary to avoid mandatory, formula-based budget cuts. Whatever the long-term benefits of such cuts might be, almost certainly they will further retard a rapidly stalling U.S. economy.

While still robust, economic growth rates in emerging countries are clearly declining. Ominously, stock prices throughout the world are falling hard. Technicians can appreciate the danger of negative trends. Ned Davis Research pointed out this morning that stock prices in all but one of 45 world markets were trading below their respective 200-day moving averages. And 78% of those moving averages were declining. Problems are clearly not local in nature.

The most acute and immediate problems are quite obviously in Europe. Bad as stock performance was in the U.S. this week, prices fell even more precipitously in the major European markets, including Germany, the Eurozone’s industrial giant. EU finance ministers will be negotiating furiously again this weekend in an attempt to cobble together a plausible rescue plan, most immediately for Greece, but ultimately for several other potential insolvency candidates as well. The success or failure of those negotiations could lead to dramatic market moves in one direction or the other in the days immediately ahead.

For the past six weeks, stocks have risen and fallen sharply within about a 10% range. Prices successfully tested the bottom of that range again on Thursday of this week. The bounce from that so-far successful test has been tepid, however, which leaves stocks still vulnerable to a break below that recent trading range. Recent price behavior has demonstrated clearly that traders are trading the headlines, which are, needless to say, plentiful given the potential for sovereign defaults and the attendant danger to banks that hold those sovereign bonds. This weekend’s negotiations, therefore, hold the potential for market-moving headlines.

Notwithstanding the likelihood of occasional sharp news-related rallies, we believe that both technical conditions and underlying fundamentals argue strongly for an ultimate, if not immediate, decline below current prices. Investors should be very careful about their levels of risk assumption.