Our fearless leaders in Washington may not always plot the best course, but this weekend they at least had the good sense to avoid financial Armageddon. With the battle over the debt ceiling now looking like it’s in the rear-view mirror, investors will be free to turn their attention elsewhere.
Unfortunately, aside from the strength of second-quarter earnings reports, there is little to suggest that any upturn in the market is likely to be anything more than a short-term relief rally. Here are four reasons why a deal won’t move stocks as much as you may think:
1) Even with the agreement, we’re not out of the woods. Although Congress managed to avert disaster this weekend, the U.S. will continue to face a long-term budget imbalance. Since the agreement does little more than delay the day of reckoning, the threat of an S&P downgrade of America’s debt will remain a dark cloud looming over the markets.
2) It’s the economy, stupid. This week brings a slew of economic data, including the all-important payroll report due out Friday. Economic releases have been nothing but bad news of late, as highlighted last week by the negative surprises in both durable goods and advance second-quarter GDP. And given the blow dealt the budget battle has dealt to investor and business confidence in recent weeks, it is unlikely this next month’s reports will provide any relief – Monday’s ISM index disappointment that pushed stocks lower was a prime example.
3) Europe is still on the ropes. The situation in Europe also remains tenuous – bond yields and credit default swaps (CDS) in Spain and Italy both rose last week, indicating that the most sophisticated investors weren’t soothed by the Greek debt deal. Further, the week brought renewed weakness in peripheral European bank stocks such as Banco Santander (NYSE:STD) and Banco Bilbao Vizcaya Argentaria (NYSE:BBVA). None of this is a sign of a market in robust health.
4) The financial markets have factored in only a modest chance of a disaster, which limits the extent of any rally. While the VIX jumped in the second half of last week, most other indicators showed only a moderate degree of fear. Consider that Treasury yields closed Friday near fresh lows (and moved lower again Monday), investment-grade credit spreads remained steady, and the high-yield market held in relatively well in a difficult week for equities. Also, the TED spread – the measure of liquidity that became so widely followed during the credit crisis – is not indicating that a new crisis is at hand, while Treasury CDS closed Friday at about 62 basis points – well above their levels of a week ago, but substantially below the peak of 141 reached during the height of investor panic in February 2009. Trading volume, while higher in recent days, also hasn’t hit the crescendo level indicating a sharp increase in investor fear. While recent headlines have been ominous, these indicators demonstrate that the markets never experienced the level of panic needed to form the basis for a sustainable upward move.
Taken together, these four factors indicate that the most likely scenario is a relief rally without any meaningful staying power. The wise course is therefore to enjoy the upturn while it lasts, but don’t get caught up in the momentum. With the looming jobs report is likely to temper any gains in the latter half of the week, any post-debt deal bounce should be used as a selling opportunity.
