A Different Kind of Decoupling

Daily State of the Markets
Tuesday Morning – January 17, 2012

Publishing Note: I am traveling the rest of the week and will publish Daily State reports as time permits.

Good Morning. There seems to be some confusion about the idea of the U.S. “decoupling” from the European debt crisis. The bears argue that there is simply no way in this globally connected world, for the U.S. economy to effectively decouple from the rest of the world should a global recession rear its ugly head again. But on the other side of the aisle, the bulls contend that their counterparts are focusing on the wrong issue.

I think most economists will agree that it would be difficult for the U.S. economy to flourish if the likes of Europe, China, and the rest of the G-20 countries are experiencing recessions. And this is especially true if the depression that many of the doom-and-gloomers are projecting hits Europe over the next decade. After all, the problem of having too much debt, not enough income, and nobody to borrow from does appear to have few answers, save a massive deleveraging cycle, which would, of course, limit economic activity.

As such, I will have to agree that unless growth can become part of the European equation at some point, the Eurozone may be headed for a tough ten years. Now toss in the renewed turmoil with Greece’s debt swap (where a default looks to be back on the table), the downgrade France et al, the new problems in Portugal and Hungary, the unwillingness of countries to “step up” in terms of funding the bailouts, and the rising debt ratio in the U.S., and it is easy to see why so many of the big boys and girls in hedgieland are SOOO negative in terms of their global macro view.

So why then are investors in the U.S. saying that our stocks look cheap on a relative basis? Why is the DJIA only a few hundred points from this cycle’s high-water mark? And why have the major indices moved steadily higher once Europe closes each and every day this year?

One assumption is the big money that must stay fully invested (think pension funds, mutual funds, endowments, etc.) is making an asset allocation shift. In short, with the overtly negative outlook for Europe, the serious money may be moving a big batch of cash back across the Atlantic into the U.S. market. Along these same lines, there is talk that with U.S. bond yields at record lows and signs that the economy may be improving, there could be another allocation shift slowly taking place – from bonds to stocks.

But in getting back to our theme this morning, I’m of the mind that another part of the equation here in the U.S. has to do with the fast-money traders rewriting some of their trading algorithms. Cutting to the chase, it appears that the computers have begun to decouple from mimicking every move that the euro currency makes. And THIS is the type of decoupling that I believe can actually continue for a while.

If you think about it, there is a little more to the stock market than the direction of the euro from a big picture perspective. But up until just recently, traders appear to have used the euro as a proxy for the state of the European debt crisis. Thus, if the euro currency rose, it meant good things were happening across the pond and it was okay to own risk assets such as U.S. stocks. And conversely, if the euro was falling, it was a sign that the crisis was worsening. So, the fast-money figured that if you got the euro right, you’d get EVERYTHING else right.

This created an insanely volatile environment during the last five months of 2011 as nothing mattered to the markets except the euro. However, this may (the key word here) be changing. You see, since about December 20th, the U.S. stock market has not been directly correlated to the euro currency. Since then, stocks in the U.S. have been able to advance while the euro has entered a free fall. And THIS is the important decoupling that I see taking place.

To be sure, stocks will fall if the crisis in Europe worsens or if the U.S. data begins to come in on the punk side. But the good news is that the boys and their computer toys appear to be focusing on something besides the euro right now. Will this decoupling stick? We shall see.

Turning to this morning… Data out of China pushed Asian stocks up strongly as analysts now expect stimulative measures from the Chinese. In Europe, decent T-Bill auctions in Spain, Greece and the EFSF have given traders a reason to buy. And stocks here in the U.S. are looking to open in the green.

On the Economic front… The Empire Manufacturing Index (designed to indicate the state of the manufacturing sector in the New York region) for January was reported at 13.48, which was well above the consensus expectations for a reading of 10.47.