The stock market seems to be paralyzed ahead of what’s expected to be market-moving news out of Europe today and Friday. At the epicenter of this likely explosion of euro zone development is the European Central Bank (ECB), but what is the news — and how will it affect the market and your investments?
The ECB Governing Council is meeting on Thursday to determine whether Europe’s key interest rate should be cut. On Friday — and this is the biggie — EU leaders on the European Council are holding their final scheduled summit meeting of 2011. There’s talk about an EU treaty change to closely monitor financial “offenders” and possibly grease the way for ECB bond buying similar to the Fed’s quantitative easing programs.
European Interest Rates
The ECB controls three key interest rates for the euro zone:
- The interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system.
- The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem.
- The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem.
How do the key interest rates affect the stock market? The chart below plots the MRO against the German DAX. It looks like a case of the chicken or the egg: Is the DAX down because of low interest rates or despite them?
Click to EnlargeInterestingly, the ECB just increased rates on July 13, supposedly because the financial system was at risk of overheating. But Mario Draghi, who took over as ECB head from Claude Trichet in November, quickly reversed that policy and cut rates by a quarter point to 1.25%.
ECB Bond Buying
Based on the current interpretation of the EU Treaty, the ECB is not supposed to print new euros to buy bonds of ailing nations (such as Greece, Italy, Spain, Portugal, etc.). Let’s just call it Euro QE.
Despite Germany’s flat-out rejection and the ECB president’s bias against Euro QE, many believe that having the ECB put a floor under bond yields is the only chance for the union to survive.
The only way the ECB is likely to ever consent to Euro QE is by being allowed to enforce a rigid system to sanction profligate governments to prevent a repeat of the debt buildup. This, however, would take another treaty change and, in my humble opinion, is like killing the dog after the bite.
Too Excited, Too Fast
While Euro QE would be huge, it wouldn’t be the first (or last) time Europe declares an end to its debt woes. Just on Oct. 27, Europe announced a “comprehensive” fix. The Dow, S&P, Nasdaq, Russell 2000, banks, financials and pretty much everything else soared that day, while the VIX was forced to take a time out.
On the same day, the ETF Profit Strategy Newsletter stated that: “The downside potential for stocks is significantly larger than the upside” and recommended to go short the S&P once it breaks below 1,275.
The next day, stocks kicked off a one-month decline that culminated in a seven-day losing streak and the third-worst Thanksgiving week on record.
Additionally, we know that QE1 and QE2 failed to fix the U.S. economy. Yes, the programs provided a boost to stocks that was as powerful as it was temporary. Not to minimize QE1’s and QE2’s effect, but Euro QE’s role will be more of a short-term interference than a long-term game changer.
How to Manage Your Investments
If Euro QE becomes a reality, we should ask, “what was the best way to invest in the QE2 environment?”
Go with the flow and don’t fight the money flow, but be ready to bail when stocks break below technical support. Watch out if the ECB fails to come out with a substantial plan.
From a technical point of view, the major U.S. indexes remain in a counter trend rally. The Sep. 23 ETF Profit Strategy Newsletter expected this counter trend and stated the following:
“From its May high at 1,370 to its eventual low, the S&P will likely have lost about 300 points (22%). This kind of move validates a counter trend rally. The plan is to square short positions and buy long positions around 1,088. The rally, once underway, will probably re-inspire a certain degree of confidence into the market before it runs out of steam. The most likely target for this rally is S&P 1,266 to 1,282.”
The Oct. 11 ETF Profit Strategy update issued the following warning: “My upside target is only about 100 points away, yet it may take about three months to get there. This means that the coming months could be filled with frustratingly choppy trading with an up side bias.”
The fact that the sideways trading continues, even after the initial up side target was reached, cautions that a higher recovery high is still ahead. However, three important trend lines and Fibonacci resistances converge not too far above today’s prices and should prove formidable resistance for the S&P.
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The ETF Profit Strategy Newsletter identifies the target range for this rally and the support that must hold to keep the short-term expectation of higher prices alive. This kind of knowledge empowers investors to be proactive instead of reactive. We’ve learned that it isn’t fun (or profitable) to be at the mercy of European news.