The New Market Cycle: Waiting For The Sell Off

Since 2008, after the financial system collapsed in a mountain of debt, our economy has been run on life support through federal spending and quantitative easing (printed money injections). This has created a new form of the business cycle that can be seen in the graph below.

Money is injected into the system (federal stimulus or QE), the market rallies, the outlook improves, policy makers take their foot off the gas, and then we have another sell off.

The arrow above points to where I believe we are in this current cycle. The stimulus from the Federal Reserve's operation twist and the European Central Bank's LTRO programs are beginning to wear off.

The chart below shows the adrenaline shot the stock market received during QE1, QE2, and the most recent combination of LTRO and operation twist.

During this time last year we began to see the economic surprise index turn down sharply meaning that economic data was beginning to "surprise" to the downside or under perform. What has happened this year? Almost the same exact process has taken place as can see see in the graph below.

The jobs data has followed an almost identical path as well. A strong spring of hiring followed by months of very weak data - confirmed by the dramatic fall off in Friday's jobs report.

Just as it did during the spring of 2011, when the market was marching to new highs the first week of May, optimism is soaring. Barron's big money poll released last month showed that 84% of money managers expected to be buyers over the next 6 to 12 months. 55% were bullish or very bullish, while only 14% were bearish.

While stocks, particularly the financials, in Europe have continued to drag lower the American market has "decoupled;" investors in American stocks believe that Europe's issues have no impact on the American economy. A topic I have come back to time and time again is the interconnected nature of our financial system and economy.

The following graph shows that almost 50% of the trade in global goods runs through Europe. As their economies slow down it is going to impact every business from Australia to Hong Kong to Brazil.

11 European countries are now in recession; Belgium, Greece, Ireland, Italy, The Netherlands, Portugal, Slovenia, the UK, Denmark, Czech Republic, and everyone's favorite conversation piece: Spain.

At the end of 2011 over 50% of Spanish government bonds were held outside the country. At the end of March this number had fallen to only 37.54%. Who was the major buyer within Spain?  The banks. Government debt on the bank's balance sheet rose from only 16.93% of the total exposure to 29.16%.

The LTRO program provided a get out of jail free card for those holding toxic Spanish debt outside the country. The Spanish banks took the free cash and loaded up on bonds while investors gladly dumped everything they could. While never announced publicly, there was obviously a behind closed doors handshake with the banks and government where the banks were promised full backing should the bonds run into trouble. While I don't need to explain to you how this process makes absolutely no sense, I think the following picture helps sum it up nicely:

European unemployment continues to surge higher with youth unemployment moving toward the stratosphere. The following chart shows youth unemployment for Greece and Spain (over 50%), Portugal (over 35%), and the Eurozone as a whole (over 22%).

The US stock market has charged higher led by the darling of the universe: Apple. The following excellent chart shows recent parabolic moves in the market and what followed. Usually a parabolic move upward ends in an even more rapid decline. Will AAPL be different?

Another great chart below shows the value of our stock market in comparison to the total size of our economy. When stocks are in favor they are bid up to extreme price levels vs. the general size of the economy. The red arrow shows when Greenspan gave his "Irrational Exuberance" speech back in 1996, just as the market was crossing over 100% of GDP. Today we still find ourselves far above Greenspan's definition of irrational exuberance although he recently proclaimed that "stocks were cheap."

We will see everything possible through the remainder of the year to keep stocks elevated and optimism running high into the election. The last thing the American people need is to look down at their 401k statement and be disappointed.

Should that happen they may look for someone to blame, and an election year is not a good time for that to occur. At least we know that should the 401k's fall there is always social security ready to stand as a safety net for the 10,000 baby boomers that are retiring every single day.

h/t Jim Sinclair, The Big Picture, Zero Hedge, Bloomberg