Here We Go Again!

Daily State of the Markets
Tuesday, February 26, 2013

Good Morning. For the fourth year in a row, the bulls managed to produce a strong rally to start the new year off on the right foot. But if you will recall, the early rallies of the last three years were thwarted by the European debt crisis. And unfortunately, for the last three years running, those rallies were followed by severe corrections. So, based on the market's reaction to the news out of Italy on Monday, I guess the only thing to say is, "Here we go again!"

But that itself is part of the problem. You see, Wall Street just loves repeatable patterns and trading on themes. Given that more than 70% of the trades made in the U.S. each day are done by robots, don't even try to convince me that the algorithms (many of which are trained to "learn" patterns via artificial intelligence) aren't chomping at the bit to get on the short side again. On that note, another trend worth noting is that Monday's have been down days in 2013. Yep, that's right; every single Monday has finished with a red number so far this year. And my guess is that this is something the AI algos are fully aware of.

But I digress. In case you took a quick glance at the early action in the stock market yesterday, smiled, and then went off to work, the golf course, or the ski slopes, let's just say that the day didn't end well. The problem was simple - Europe seems to be back again. And since the European debt crisis trade is old hat to the algos as well as every other self-proclaimed fast money trader on the planet, the computers tied their trend trades to the euro yesterday. Almost tick for tick, when the euro went down - and it went down a lot after the Italian press got the election outlook completely wrong - stocks went down too.

If you are wondering what the heck Italy has to do with the U.S. stock market, you are not alone. I mean seriously, after everything we've been through over the last four years, does an election in Italy really matter all that much? It is now obvious that the Eurozone isn't likely to crumble apart any time soon. It is also obvious that the ECB will take action if things get ugly again. So, from a big picture standpoint, Italy probably doesn't matter much. However, we need to keep in mind that in the markets, "it's not the news, but rather how the market reacts to the news that matters."

In short, the market's reaction to the news that Italy's election may have been a draw was violent as the series of sell programs reminded me of the bad-old days of the European crisis. Stocks were hit hard. Then they were hit hard again, and then again (oh, and then a couple more times for good measure into the close). Granted, there may not have been much buying interest in front of the actual election result. But, if we want to stay in tune with what the market is doing and why, then we've got to understand this whole Italy thing.

To review (as briefly as possible) there are two main candidates: Pier Luigi Bersani - the candidate who is pro-reform and represents political stability and Silvio Berlusconi, the former Prime Minister who was ousted due to various scandals. Simply put, Berlusconi is anti-reform and anti-austerity. While it would be logical to assume that a scandal-ridden former PM didn't really have a chance at making a comeback, as one analyst put it yesterday, "People get used to getting free stuff from government." So, surprise, surprise, with Berslusoni running around promising people "stuff" his popularity appears to be rising.

Again, why does this matter? Here's the deal... The fear is that if Berlusconi returns to power, the reforms, which the Monti government put in place to appease the Eurozone and the bond market (which are working, by the way), will be reversed. And if that happens, the bears tell us that yields will spike, the rate contagion will resume, and the word "bailout" will return to our daily market lives. Thus, things would be much better for the markets (stock, bond, and currency markets alike) if Bersani were able to win control.

The good news is that Bersani appears to have won the house by a slim margin. However, the problem appears to be that Berlusconi's party has won a narrow victory in the senate. And thanks to a quirk in Italy's system (the rules are too long and boring to detail here), the former PM's party would get more seats in the Senate. Thus, it appears that there is a "hung" government, meaning that neither party has enough seats to govern. And this means another election may be needed.

The election result brings uncertainty back to the markets as investors fear that the Europe debt crisis will return - yes, AGAIN! And uncertainty brings out the bear algos, which had the run of the place yesterday. What was interesting though is that the bears weren't focused just on Italy. The glass-is-half-empty gang also spoke of the sequester, the Fed, and a "key reversal" day. From my perch, it was as if even they didn't believe Italy was a good enough reason to tank the market. No, it was more about the idea that stocks "need" to go down. Can you say "self-fulfilling?"

So, will Monday's shellacking turn into something serious? Will Europe once again turn a good start into a severe correction? Although I'm not sure about the answer or even the validity of the reasoning behind yesterday's dive, most folks I talked too were all saying the same thing yesterday, "Here we go again."

Turning to this morning... The overnight action was downright ugly as Asian markets were down across the board and European bourses continue to fall this morning. The general concensus is that the European debt crisis is back and banks around the world are falling in value. However, U.S. futures are currently positive. Possible explanations include Home Depot's better than expected earnings and a move down in the U.S. dollar. The key though is if the U.S. market will be able to hold up in the face of the global decline.