Europe, Don't "Draghi" Your Feet - Selling our International Stocks

We grew more negative on international markets in our portfolios last week when some key longer term technical breakdowns triggered our International Market Trend Analyzer.  We have entered what we call our "Trading Phase" - where we are decidely more short-term oriented and biased toward cash unless we see concrete signs that the market is moving higher.  This indicator is right a little more than half the time, but losses from false signals are small, while payoffs from winning trades are very large.  It historically tends to trigger at moments of no return for markets, where the potential for a panic has increased.  The loss of confidence, combined with an utter lack of response from policy makers has the potential to create a feedback loop, making the ultimate policy response much larger than it would need to be originally.  As Buffett has said confidence is like oxygen.  You forget how important it is until you run out.

Click on the image above to view a larger chart.

That's the bad news.  The good news is that there are already encouraging signs, enough so that it is likely that we could shift half back into international equities in a matter of days if international markets can hold these levels.  We also think the issues facing Europe at the moment can be resolved more easily than the experts suspect.  That resolution in place, global markets will melt up.  Sentiment is too dire and stocks are too cheap to expect much else.  However, after doddling for well over a year now, it is now put up or shut up time for leaders in Europe.  Unfortunately, they pushed markets to the point where a credit crunch in Europe is underway.

The real tipping point this year was not some new fiscal revelation by bond investors.  The euro crisis began in earnest this spring, right as both QEII was ending and the ECB began to tighten rates.  See our chart below.  The MSCI Europe Index peaked right as our measure of euro area velocity indicated that money in the euro area had turned restrictive.  Notice how this coincides perfectly with the rate hikes by the ECB in the 1st Quarter of 2011 and gets worse with the second hike in the summer. The ECB caused the 2011 crisis.  Unfortunately, the longer they wait to reverse course, the more liquidity that they will ultimately have to provide.  To which we say to the new ECB chairman, Mario Draghi, we hope that your last name has no bearing on how swiftly you make decisions.  Fortunately, the ECB has already taken one step in the right direction.

Click on the image above to view a larger chart.

Here at home, US stocks are not close to a similar technical breakdown and appear to be a safe haven in this environment.  Stocks like mega cap Microsoft (1), for example, are the mirror image of 12 years ago - as inexpensive now as they were expensive then.  Even for Microsoft, it is hard to foresee a situation where it doesn't return double digits over the next 5 to 10 years, barring some crazy use of capital, say a $50 billion investment for the invention of the Flux Capacitor.  We use this as an example, but we see this broadly.  Sentiment is so dire, and stocks are so inexpensive that a market melt up seems inevitable.

Finally, if you come away with one lesson from this volatile 2011 it might be this - have more confidence in the US dollar.  It is still the only reserve currency in the world, and it will likely be that way for at least the next 50 years.

Mark Dodson, CFA

(1) Hays Advisory doesn't currently have a position in Microsoft.

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