How the Dollar and Europe's Ireland Moves Will Steer Fate of U.S. Stocks

Stocks retreated over the past week following an earnings warning from tech giant Cisco Systems Inc. (Nasdaq: CSCO), renewed tensions in Europe over the ability of Ireland to pay its debts and a surge in the U.S. dollar.

Overlaying the action was word out of South Korea that the G-20 meeting of leaders of the world's largest economies was not going well, with European and Asian leaders expressing exasperation with U.S. monetary stimulus and a distaste for U.S. President Barack Obama's scolding tone on export targets.

In prior decades American trade policy makers did not have to pay much more than lip service to overseas financial leaders because we held an unparalleled position atop the global dog pile. But now we are deeply, deeply in debt to China, Japan and Germany, and these creditors feel increasingly entitled to look down their nose at us with a mixture of disbelief and distrust.

I hate to read too much into a single meeting, but the video and communique sure made it look like the financial soul of our country was under scrutiny in Seoul, and not in a good way. If those countries were to decide not to buy our bonds in a material and lasting way, or challenge the U.S. Federal Reserve's new quantitative easing effort by launching a competitive counter-action, it would be very unfortunate and uncomfortable.

Such a move would hurt them, to be sure, because they have more than $4 trillion of our bonds locked up in their vaults, and they sure don't want to see the value diminished. But they may someday reach the breaking point and take a chance.

All the major U.S. indexes slipped Friday by 1.2% or more in an orderly manner, with one important twist. As you can see in the chart above, the Standard & Poor's 500 Index has been rising since the start of September up its 20-day exponential moving average. The first close below that level, now at 1195, could be the start of a trend change, though there's also some close-by support at 1,180.

I have been saying since October that a decline of around 5.0% would be normal and even necessary to reset the kinetic energy in the markets. From the recent high of 1,224, that would be 1,160, which also happens to be the 50-day average and a congestion level in early October that could provide the kind of support at which long-term buyers would materialize. It would seem painful on the way down but such a jolt out of complacency is absolutely normal in all uptrends.

Breadth across the three major U.S. exchanges was 2-1 negative last week, and by Friday there were just 106 new highs vs. 43 new lows, showing that the advance of recent winners has definitely been blunted. The exchanges were showing 900-plus new highs in the first week of this month.

I cannot overemphasize enough the fact that the dollar's advance appears to have ignited the recent chain of events. When the buck rises in value, traders who have sold it short as part of a "carry trade" are forced to buy quickly to cover their position. To raise the funds they typically sell risky assets around the world that they had purchased.

This is exactly the action that we saw back in the second week of August -- a dollar-based chain reaction that led to a decline in U.S. stocks for three weeks. That ebb tide was only reversed once Federal chief Ben Bernanke made a speech in Wyoming that essentially confirmed the central bank planned to launch a new round of quantitative easing to stimulate the U.S. economy.

I apologize that my chart is a little complicated but I wanted to make sure you saw all the relationships. The bars in the top clip are the U.S. dollar; the line in the bottom clip is the S&P 500. When the dollar rose over its 30-day average (red line) in August, it was a day ahead of the decline of the equity benchmark index. The S&P 500 did not bottom until the dollar started falling again late in the month. Then the dollar fell all through September and October, with a couple of one-day jumps that you may recall (in which they touched but did not climb over the 30-day average). The past ten sessions featured some jostling, but there were no closes over the 30-day moving average until Tuesday.

So now push comes to shove. If global macro traders are serious about taking the dollar higher, then U.S. stocks may be in the dog house for awhile.

It's really an incredible game of three-dimensional chess, with the massively huge currency and bond markets as the main players and the much smaller equities markets essentially a pawn that gets swept along. Just to add sizzle, sometimes the rules change and the players are not notified until after the fact.

Bottom line is that the Federal Reserve sparked this recent set of events with its decision to stimulate the economy by inflating the money supply. The narrative was acceptable and smooth until the Irish banks started to wobble. You may find this hard to believe, but the reality now is that if the Europeans decide to help the Irish with their debts, then the euro will strengthen, the dollar will fall, and U.S. equities will straighten out -- and quite possibly soar. It's going to be a wild one.

Company Roundup

Bulls' mettle was really tested on Thursday following an earnings report after the bell from Cisco Systems that was merely in line with expectations. The company's longtime chief executive, John Chambers, who was always Mr. Happy Guy during the tech bubble years, fulfilled his more recent reputation as a much more dour leader in comments to analysts. He described a corporate investment environment that is very slow to improve.

My expectation is that the sour mood will be largely contained to Cisco however because its troubles is that its closest rivals, such as Juniper Networks Inc. (NYSE: JNPR) and Hewlett-Packard Co. (NYSE: HPQ) are starting to eat its lunch and push it around the school yard. These companies, as well as upstart F5 Networks Inc. (Nasdaq: FFIV) have already reported earnings and offered buoyant outlooks.

We are witnessing a lion in winter as Cisco's relevance fades. The company has grown to its current size via serial acquisitions. Its products are pervasive but do not have a reputation for quality and it has not innovated for years. Cisco has really stretched recently for growth by adding video conferencing products, cable boxes and even the Flip video camera line. It's pretty ridiculous.

The stunning lack of important new products at Cisco really comes to life when you look at competitors like F5, which I have recommended for 10 years, and most recently in February this year. There is no way that Cisco should have given up ground in the network room at large companies to an upstart like FFIV way back in the late 1990s, and yet it has never come up with a competitive product in that space. FFIV created a $9.9 billion business in application delivery controllers that are crucial to the way content is delivered on the web while Cisco was busy buying Flip cameras. It is sad to see how badly Chambers has let this once august company slip.

Keep in mind that Cisco is in the Dow Jones Industrial Average as well as the S&P 500 and Nasdaq 100, so its 18.0% decline alone is depressing those indexes. But as you can see in that chart, Cisco ceased to be relevant years ago. It is not quite a dead man walking, but close enough.

The bottom line is that the indexes may suffer a setback for a few days but I do not think that Cisco's troubles will translate into trouble for the entire market.
After all, whenever there has been a streak of good news to lift spirits in the past two years, a set of doubts are sure to creep in. At the moment those doubts include global backlash against the Fed's decision to pursue quantitative easing, new concerns about the potential for sovereign debt defaults on the periphery of Europe and margin concerns at food makers and apparel makers that face soaring grain and cotton prices.

Yet keep in mind that although the major indexes are still well below their 2007 or 2000 peaks, there are scads of major industrial, retail and service companies that have fully embarked on their own private secular bull markets. Not cyclical bull markets, mind you: Secular, as in fully above all prior highs. IBM Corp. (NYSE: IBM), Caterpillar Inc. (NYSE: CAT), Goodrich Corp. (NYSE: GR), AutoZone Inc. (NYSE: AZO) and Limited Brands Inc. (NYSE: LTD) are shown above, but there are many more.

This is important to understand because it tells us that any downdrafts such as the one this week, even if they persist for two weeks or more, will occur within the context of a major up move for companies that is largely free of the taint of quantitative easing. It's just normal companies like IBM grinding out their normal businesses and earning normal valuations. For these companies, and most of the ones on our list, the bear market is done like dinner and they're on to the next thing.

On the plus side of the economic news ledger was word from surveyors that that small business confidence in October hit its highest level in five months. That's very good to hear.

On the negative side was a very weak session for the banks, as Wells Fargo & Co. (NYSE: WFC), Bank of America Corp. (NYSE: BAC) and JP Morgan Chase & Co. (NYSE: JPM) gave up some of the gains made earlier in the month. A key sticking point for banks was a news report that local judges were being very lenient in foreclosure rulings, with one giving a house to a plaintiff due to his findings that a bank's mortgage servicing mistakes were "repugnant." These banks are the main reason that the big-cap indexes are not much higher. The sooner they get real traction, the sooner the business climate, and hiring, will improve.

Energy performed well in part because of the announcement of a major acquisition of a Marcellus Shale play by industry goliath Chevron Corp. (NYSE: CVX). Evidence is starting to emerge that crude oil could make a big run higher toward the end of the year along with the agriculture complex, by which I mean fertilizer producers, farm equipment makers and Midwest- and Southwest-based regional banks and retailers.

Week In Review

News flow was very light in the past week as there were few major economic reports or earnings releases. Discussion on trading desks was mostly limited to reappraisals of what quantitative easing will really mean for equities and bonds.

One report to focus on though was the Federal Reserve's release of its quarterly survey of senior loan officers, which provided some useful color on what is happening in the trenches. Here is what we learned:

-- There's been a disturbing decline recently in demand for new loans and a renewed tightening of credit conditions for residential mortgages and other consumer loans. This news provided new evidence that the Fed needed to act. The greater excess reserves that banks will accumulate under quantitative easing will give them the potential to expand their lending quite dramatically.

-- Lenders remain reluctant to lend and borrowers remain reluctant to borrow, supporting the view that U.S. economic growth will plod along at 2.0% annualized in coming quarters.

-- Over the past few months, the overall value of loans to businesses has stabilized, after contracting by about 24% between mid-2008 and mid-2010. The loosening of lending standards implies we could see business loans rebound by about 12.0% over the next 12 months, reversing roughly half the original contraction. That's the good news.

-- Unfortunately the bad news is that the banks reported a weakening of demand in the October survey, not just for business loans, but mortgages and other consumer loans as well.

-- It's mostly small firms that are shying away from taking on debt. With cheap and copious financing available in the bond markets, it would be natural to see larger firms borrow less from banks. But small firms don't have these alternatives. Instead, it appears these firms that are so important to the vitality of our economy are so concerned about the outlook that they are scaling back plans for investment and hiring. That's the big, persistent problem: No confidence.

This is why market strategists are so focused on whether the new round of monetary stimulation from the Federal Reserve will help. Goldman Sachs Group Inc. (NYSE: GS) economists sent a note to clients last week arguing that since unemployment and inflation are much lower than the levels consistent with the Fed's mandate, the central bank ultimately will need to move well beyond the initial round of $600 billion in Treasury purchases.

Goldman expects that QE2 will ultimately require as much as $2 trillion in bond buying. As a result, the analysts added that the market should not fret that positive data surprises like those seen last week will derail the Fed from its mission.

My perspective: The Fed is not going to be shy about QE2. It is not going to undershoot. It will overshoot. This will make a lot of skeptics squawk and squirm, but this is how chairman Ben Bernanke has said he would operate. Don't think he won't do it.

While this points to a perilous period just ahead for businesses, keep in mind that the Fed has never failed in its mission in the past century. There will be bumps and hiccups, but bulls are in control and stocks are likely higher.

The Week Ahead

Now here is a list of the major economic news releases scheduled for the coming week. The most market moving ones are listed in bold. They are all in improving trends except housing.

Major Economic Releases of the coming week

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