Borrowing costs in Italy and Spain continue to be reliable barometers for the status of the European Debt Crisis. If Italy and Spain lose access to the credit markets, the house of cards would finally come tumbling down. As I write this, 10-year yields in Italy and Spain have spiked to 6.38% and an alarming 7.52%. Yields of short-term debt in both countries have also risen dramatically, making it increasingly difficult for Italy and Spain to fund their oppressive deficits.
There is an interesting phenomenon taking place in the debt markets of the stronger European countries as well: two-year yields in Germany, Switzerland, Denmark, Austria, Finland, and the Netherlands are now negative. Investors are willing to pay the European governments with better credit to safeguard their money for two years.
This has ominous implications for the entire European banking sector. If investors are willing to accept negative yields for two years, then they must not trust European banks, even in the stronger countries. Why not? Because European banks are highly levered and they own Greek, Spanish, and Italian debt.
Not surprisingly, equity markets in Italy and Spain were pummeled on Friday and have suffered further declines so far today. However, equity market losses were not limited to Italy and Spain. Most global equity markets dropped on Friday and are suffering even steeper declines today.
On Friday, FactSet reported that 74% of the 104 S&P 500 companies that had reported earnings beat their mean estimates. That may seem impressive, but the estimates were very conservative. In addition, the quality of the earnings was questionable: FactSet reported that only 45% of those companies beat their sales or revenue forecasts. This was the weakest sales reading since the first quarter of 2009 – at the end of the last recession.
As I have mentioned before, earnings are reported with a lag. As a result, reported earnings trail the market. However, some companies also offer forward-looking earnings guidance. As of last Friday, FactSet reported that 22 companies had issued earnings guidance for the third quarter of 2012. Of those 22 companies, 18 issued negative EPS guidance and only four offered a positive outlook. In other words, 4.5 companies issued negative guidance for every one company that offered positive guidance.
Summary Market Indicator Score
My summary market indicator score combines the bullish or bearish readings from 34 separate data series. The indicator score has three main components: technical, breadth and relative strength, and economic indicators that tend to lead the market. All indicators are on a scale of -100 (max bearish) to +100 (max bullish).
As of last Friday, my summary market indicator score was -1.2. However, there continues to be a divergence in the components of the score. The technical, breadth and relative strength components continue to be positive, while the economic indicator score was -41.
Europe is already in a recession and it looks like it could be a long and painful one. There is significant event risk in Europe as a cascade of sovereign defaults becomes increasingly likely. China and the emerging markets are slowing dramatically, the U.S. economy is weakening and may already be in a recession, and we are rapidly approaching our own fiscal cliff. Even with the sell-off on Friday and again this morning, the equity markets have not factored in the burgeoning risks of a major economic contraction
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