In recent weeks several people have indicated to me that they do not understand why economic and debt problems in Europe are impacting U.S. markets. So I am going to try to explain this in a way that any investor can understand.

To begin, it is important to recognize that in today’s world, the economies of virtually every country are closely linked. That is particularly true of the U.S. and Europe. Many of the world’s largest companies do massive amounts of business on both continents. Many are headquartered in Europe but do the bulk of their business in the U.S.

The economic ties that bind Europe together are almost as strong as those among states in this country. So when Greece gets in trouble, the rest of the nations in the European Union are essentially forced to come to the rescue.

Here is an analogy: A 16-year-old is driving the family car. Perhaps he is doing something reckless like speeding, texting, goofing around with a friend, etc. He is involved in a serious accident with another vehicle. He is at fault. Both cars are totaled and someone in the other car is seriously injured.

Even with the protection of insurance, the repercussions of this event are going to impact the lives of both families for quite awhile. One family will be dealing with hospital visits and expenses, insurance claims, replacing a vehicle, and more. The other family will face possible legal issues, higher insurance premiums for years, replacing a vehicle, and much more.

While the 16-year-old driver might have been at fault, many others will be touched by the ripples of the aftereffect.

That is similar to what is occurring in Europe.

Many countries in the world—including the United States—are struggling with economic difficulties. Most—including the United States—have temporarily tried to resolve those issues by taking on additional debt. While that might have solved an immediate crisis, the underlying issues remain to be resolved.

Here is another analogy: Unforeseen circumstances result in a significant income reduction for a family. They quickly use up all of their savings and max out all of their easily available sources of borrowing. It becomes more and more difficult to pay their bills and finally personal bankruptcy seems likely. Unexpectedly, they receive an offer for a new credit card account with a $20,000 line of credit. Their application is approved, and thanks to the new credit line, they can continue to pay their obligations.

Obviously this new credit line is only delaying their day of reckoning and not really solving any problem. To climb out of their financial hole, the family must find a way to increase income, reduce spending, or both.

Once again, this is similar to the situation currently facing many countries. A severe economic downturn means their revenues have shrunk. They are struggling to pay debts and obligations already incurred. By taking on new debts, they are merely postponing the time when they must increase revenue or decrease spending.

After a substantial market rebound in 2009, many investors erroneously believed that the crisis was over. But most of the underlying problems that created an unsustainable economic situation remain.

Nouriel Roubini is a professor of economics at New York University’s Stern School of Business and chairman of Roubini Global Economics, an economic consultancy firm. In a recent interview in BusinessWeek he remarked, “The first lesson is that crises are not ‘black swan’ events … they’re not just random outcomes. They are the result of a buildup of financial and policy vulnerability and mistakes — excessive risk-taking, leverage, debt, and so on.

“They are ‘White Swans’ “because these events are predictable. But generation after generation, we seem to forget the past. When there’s a bubble, there’s euphoria. There’s irrational exuberance. Consumers can use their homes like ATM machines. Governments and policy makers are happy because they get re-elected. Wall Street makes billions of dollars of profits. Everybody’s delusional.”

Governments can influence their markets and economies in a variety of ways. But one factor they cannot control is investor sentiment or emotion. Most monetary systems are based largely on trust. Once the public no longer trusts the government that manages the system, it loses control.

If Greece goes bankrupt, then every country or corporation connected economically to Greece will have losses that must be absorbed. That could force them to call in debts from other countries like Portugal that are also on the brink. From there, the dominoes could start to fall and the euro would likely cease to exist.

It is worth mentioning that no one wants to see any of this occur. And no politician wants to be in office when there is an economic collapse. So governments world wide are doing everything within their power to make certain that if the worst-case scenario occurs, it will be after they are no longer in office.

When it comes to the financial and investment markets, that means if they can find ways to keep the markets from a sharp decline, they will. So although we have seen some sessions of significant downward volatility, no one can say for certain that this is a trend that will continue. For now, the watchword for investors should continue to be: caution.

One of our subscribers, Richard Burns, recently made me aware of a project he is working on. It is a web site: www.deficitaid.com. It is a resource about deficit awareness and includes articles on federal deficit spending: history, solutions, charts, videos, and national debt. I’ve looked it over and it has some great information. I encourage readers to check it out.
F.S.

Over the past year, some of our clients questioned why we continued to adhere to a conservative investment approach when stocks were advancing.

In spite of strong market gains in 2009, we believed that market risk remained high and that the economic recovery might be too fragile to endure. Events so far this month seem to support that reasoning.

The one-day market slide on May 6 is being called the “Flash Crash.” A May 18 article by Wall Street Journal reporter Scott Patterson noted that the May 6 slide had similarities to the Black Monday crash of 1987.

“Technological innovation has been widely touted as having made the market more efficient—and more resilient. Instead, the May 6 drop—while much smaller than the 1987 crash—showed that technology mainly served to speed up trading and magnify the market moves.”

The article noted that the worst portion of the May 6 descent lasted about 10 minutes. The decline was 9.8% at its worst point and trades reached 19 billion shares.

Although stocks quickly recovered much of the May 6 loss, it still should serve as a warning to show how quickly the situation can unravel.

Before that one-day demonstration of volatility, there were signs that the U.S. still faces daunting economic challenges. And while stocks can rise during a weak economy, there is usually a time of reconciliation.

In a May 17 Fortune article Shawn Tully also referenced the 1987 crash:

“Don’t be deceived by the rebounding economy … Right now, stocks are extremely vulnerable to the same scenario. The reason: The market is even more overpriced than when thunder struck on that distant Black Monday.”

Tully’s article explained that the 60-year price-to-earnings ratio (P/E ratio) of the S&P 500 is slightly less than 14. After the market correction that began in late 2007, the P/E ratio fell to 13.3 in March 2009. That was the same level reached after the 1987 Black Monday crash. By May 2010, the P/E ratio climbed back to 22.  (See below for a more detailed explanation of P/E ratios).

“So what do the current … PEs tell us about the future of stock prices? The best bet is that equity values, like most investments, revert to the mean.”

Then Tully notes what returning to the mean would entail:

“How far must prices fall to get back to basics? For the S&P to return to a PE of around 14, the index would need to drop by around 33% to less than 800, its range in early 2009. That would substantially raise dividend yields, and raise future real returns into the high single digits, where they belong.”

It is important to understand that no one knows exactly when that move to the mean will occur. It could be next month. It might not be for 10 years.

As measured by most technical indicators, major stock indices have turned negative. The Dow, the S&P 500, the Nasdaq and the NYSE composite are all below their 200-day moving averages. Other indicators like the moving average convergence divergence (MACD), relative strength index (RSI), and stochastic oscillators are negative and reflecting high levels of selling pressure.

Unfortunately, even the best tools in the world cannot tell us what the financial markets will do over the next few sessions. All the information means at this point is that from a macro-economic view, the economy remains relatively weak and market risk is elevated. Even so, strong upward market moves can occur, as we witnessed for much of 2009.

But based on what is currently happening in the economy and the markets this is a time for caution and not speculation.
F.S.

A week ago I said it was too soon to declare that the bull trend in place since March 2009 was ending. That same day the Dow dropped 1000 points, although it regained quite a bit of ground before the close. And in spite of the week’s volatility, today most major indices are close to where they were a week ago.

Many investors are no doubt looking back on the past week and wondering about the meaning of such large daily swings in the financial markets. The simple answer—and perhaps the most correct—is that market risk levels remain high. Such big daily moves also show that traders and investors remain fearful about the economy.

Because of that fear, stocks remain in a precarious position. The past week’s nervousness was generally attributed to economic problems in Europe—specifically Greece. But several other countries around the globe face similar challenges. And any of them could be the next catalyst for a major market downturn.

The chart below of the S&P 500 illustrates how quickly the technical situation can change. The blue line is a 50-day moving average (MA). The 50-day MA is a good indicator for identifying intermediate market trends. A week ago the S&P 500 was resting right at that mark.

The gold line is a 200-day MA. It is usually a useful tool for identifying changes in longer trends. Many traders and investors use the 200-day MA as a fail-safe type tool to help decide when stocks move from bullish to bearish and visa versa.

As the chart shows, on May 6 the S&P 500 moved from the 50-day MA down to the 200-day MA in a single session. Such moves are rare. Fortunately, the market rebounded and the S&P 500 and other major indices ended the day well above their 200-day MAs.

This kind of move illustrates that even though stocks have been in an upward trend for more than a year, investors still need to be cautious. Just because stocks are on an upward path does not mean that all is well with the economy. When stocks move up, investors sometimes begin to fear that they are somehow being left behind. But it is important to remember how quickly stocks can drop once fear takes hold on Wall Street.

This time investors got lucky and the downturn was quickly erased. That might not be the case next time.

F.S.

For months we’ve warned investors that the economy remains shaky and the financial markets still carry high levels of risk. With this week’s market pullback and the significant economic troubles confronting Europe, this would be a great time to say “I told you so.”

It would also be premature.

There is no disputing that the economic challenges facing Greece, Portugal and other European nations at this time could have serious worldwide repercussions. One of those could be a new, global recession.

But so far, the damage to U.S. investment markets is not severe enough to pronounce an end to the rally that began in March 2009.

The accompanying chart provides a clear image of the technical situation. The top portion of the chart shows daily price movements of the S&P 500 over the past two years. The gold line is a 50-Day Simple Moving Average (MA). The blue line is a 200-day MA. The S&P 500 has broken slightly below its 50-day MA. Since the current rally began in March 2009, this index has on three prior instances fallen below its 50-day MA. Each time it recovered and resumed its upward trend.

If it falls below its 200-day MA, that would be a clear signal that the advance has failed and a more serious bear market correction could persist.

Immediately below the top portion of the chart is a moving average convergence divergence (MACD) tool. While the MACD is falling, it has not yet gone negative and it is near a level where a rebound is a possibility.

The next portion of the chart is a stochastic oscillator. This tool is at an oversold level that would normally indicate a rebound is likely.

Finally, the bottom portion of the chart is a relative strength index (RSI). This indicator has dropped below 50, meaning that momentum for the S&P 500 is now below the level needed to sustain an advance. But it has not yet fallen to the low it reached in February 2010 and it is certainly not yet trending below that 50 mark, which is what we would expect in a new bear market.

The current situation could continue to deteriorate and in a week or two, if these indicators could all show a much more negative picture. But for now we must rely on the image we have—that of a market at risk but one where it is too early to declare that the tide has turned.
F.S.