Euro hitting new lows! Earnings slowing! Bonds throwing off major warning signs!

Mike Larson

For a couple of months now, I’ve been getting increasingly cautious on the markets. The list of reasons is long: The global economy is slumping fast. The euro crisis is deepening by the day. Fiscal policy is frozen and monetary policymakers are out of bullets.

Now, all of those forces appear to be coming home to roost! Just in the last few days …

* The euro currency plummeted to 1.22-and-change against the U.S. dollar! Not only did that decline completely erase the very short-lived gains achieved in the wake of the latest “Summit to Save The World,” but it also sent the euro to the lowest level since July 2010.

* The anemic rally in stocks reversed right at technical resistance! S&P 500 futures failed right around 1,370, as I suspected. That opens the door for a retest of the lows in early June — at LEAST. That level was 1,262.

Meanwhile, overseas markets continue to drop like a rock — China’s Shanghai Composite Index just hit a six-month low, while Brazil’s Bovespa is trading near its lowest level since October.

* Earnings warnings are coming fast and furious! The big picture economic news has been stinking up the joint for a while now. But whenever someone on CNBC points that out, some two-bit fund manager comes on and says “Yeah, but corporate earnings are still sound so that’s okay.”

So much for that argument!

Just in the past several days, we’ve gotten profit warnings from major semiconductor firms likeAdvanced Micro Devices (AMD) and Applied Materials (AMAT) … heavy industrial and transportation companies such as Cummins (CMI) and Ryder Systems (R) … and companies with consumer spending exposure, like Ford (F)hhgregg (HGG) and Burberry (BURBY).

In fact, the ratio of negative to positive profit guidance announcements is running at a whopping 3.3 to 1 for this quarterly earnings season. That’s the worst going all the way back to the fourth quarter of 2008! I probably don’t need to remind you that was in the depths of recession, and that the Dow was trading in the 8,000s!

Why else am I worried about stocks? Because
the “smarter” bond market is freaking out!

There’s been a long-running assumption in the capital markets that bond traders are inherently smarter, and more rigorous, than their stock-trading brethren. I happen to agree.

Bond traders often pick up on a trend before stock traders.
Bond traders often pick up on a trend before stock traders.

That’s not just because I follow bonds very closely! It’s because I’ve seen the bond market send out early warnings time and again —warnings the stock market doesn’t react to until days or weeks later!

Right now, the divergence in interest rates between perceived “safe haven” countries and those with huge debt problems is exploding. Our 5-year Treasury Note yield sank to just 0.61 percent this week, within a whisker of the lowest in recorded history (set in early June). Germany just auctioned off 4.15 billion euros worth of 10-year notes at a yield of only 1.31 percent, the lowest ever.

Meanwhile, Italian 10-year note yields have given up all their post-summit gains and were recently at 5.8 percent. Spanish yields are hovering around 6.5 percent, a level so bad it forced the country to announce a new package of tax hikes and government spending cuts. They’re designed to reduce Spain’s deficit by 65 billion euros over the next couple years in order to appease bondholders. But they’re only going to deepen that country’s recession in the process!

Why I’m keeping my eye on a
key interest rate spread!

That’s not all, either. Take a look at this chart below. It shows the spread, or difference, between yields on the 10-year Treasury Note and the 2-year Treasury Note in red. It also shows the price performance of the S&P 500 Index in blue.

You can see that they tend to track each other fairly well. That’s because the “2-10 spread” is a good expansion/contraction indicator. When the spread widens out, that’s generally a sign the economy is expanding and that investors are willing to take on more risk. When it contracts, it’s a sign that the economy is weakening and risk aversion is gaining steam.

What I find remarkable is that the 2-10 spread is sending off a huge warning here! It’s sinking to levels we haven’t seen in more than three years when the economy was just beginning its anemic rebound phase from the depths of the Great Recession.

Yet for the past couple of months, the stock market has tried to ignore that signal. The reason? Stupid hopes on Wall Street that QE3 will somehow succeed where QE1, QE2, Operation Twist 1, Operation Twist 2, LTRO1, LTRO2, etc., etc. all failed!

Me?

I have no doubt in my mind that Fed Chairman Ben Bernanke is contemplating another round of QE. I just believe that QE — Quantitative Easing — is turning into “QU” — Quantitative Uselessness! If it has any impact at all, it will be extremely fleeting — just like we saw with the last European summit, which only managed to boost risk assets for a couple of days.

Long story short, I believe the bond-stock divergence is at high risk of collapsing … not by the 2-10 spread widening out, but by stocks tanking! And like I said earlier, it almost always pays to bet with the bond market pros versus the stock jockeys!

So please, if you haven’t already dramatically dialed down your stock exposure … or added protective positions like inverse ETFs and put options … do so now. Before it’s too late!

Until next time,

Mike Larson

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