The View From 30,000 Feet: Italy and The State of the U.S. Economy

News out of Europe has a more positive and bullish tone this morning. We have reports of progress being made on governmental transitions in both Greece and Italy. In fact, the Italian budget deal is being fast-tracked with approval possible in a couple of days. There are reports that if this does happen then Berlusconi could step down this Sunday, clearing the way for a new Prime Minister.

The markets are hoping that a new government will bring some stability and will move quickly to resolve Italy's various problems.

As I see it this is wishful thinking at the moment. There could be a brief market celebration but I am not confident that anything substantial will be accomplished in the near future.

Italian bond yields are basically holding steady. The rate on 2-year notes is declining somewhat. It has been reported that the ECB is in the market buying Italian paper.

We should shortly have information on today's Italian auction of 1-year notes. The results of that offering could move the markets. At this time though, the 10-year yield remains above 7% (7.086%) while the 5-year notes are yielding over 7.3%. Italy thus has an inverted yield curve; almost never a good thing. And while the 2-year note yield has dropped to about 6.9%, it seems that this is due to heavy ECB buying.

Italy remains a big problem. We should also not forget about Greece, Portugal and Ireland. On top of those we have concerns building regarding the French banks and their massive holdings of European Sovereign Debt. It just keeps getting better and better.

Stepping back a bit from the trees and looking at the forest, it does seem that the realization is dawning that Europe is entering a recession, if it isn't in one already. Remember those recent PMI figures that were in the mid-40's? If in fact Europe does slide into a recession that will have significant global impacts. A recession in Europe could lead to a decline in economic activity in China and the U.S. as export activity to EU members is reduced.

And as the dominos continue to fall, we could eventually see the U.S. economy roll over into the dreaded "Double-Dip". A forced, albeit delayed, recognition of this eventuality would almost certainly lead to some dramatic downward adjustments of analysts' now rosy 2012 earnings estimates. Coincident with that earnings reduction process, I would certainly not be surprised to find that the next bear market begins to unfold. With 2012 estimates now generally factoring in double-digit earnings growth and with those estimates being widely accepted as "fact" and built in to valuations, downward estimate revisions could be expected to be an ongoing negative "surprise" for traders and investors alike.

Of course this is just theorizing on my part.

However, let's recall the September 30th warning from Lakshman Achuthan of the Economic Cycle Research Institute that the United States was "tipping into a recession" and that it was "unavoidable". He also mentioned that their conclusions were made without factoring in any "external shocks" and that if such did occur (think Europe) they would simple make whatever recession was already in the cards just that much worse.

In recent interviews the ECRI folks have reiterated their forecast. They have also mentioned three other items:

• It is common for the consensus to be at odds with their forecasts. In April of 2008 a poll of economists had 95% saying they saw no slowdown for that year. (Missed that one!) Historically the "opinion gap" between ECRI and the crowd is resolved by the crowd moving toward the ECRI prediction.
  
• Most recessions in the past 100 years have begun in quarters which had been reported to have positive GDP growth. Therefore the fact that Q3 GDP was recently reported to be at +2.5% is not inconsistent with past experience.
  
• It is also not unusual for the market to rally following an ECRI call. In fact this is often seen, they claim, since the market players look at backward-looking, coincident or short-leading economic data and act upon those. It is only later that those data series will reflect what the long-leading indicators are telling ECRI now. Therefore the market decline often lags the ECRI call.

On this last let me add my own observations. Remember that the market indices were hitting multi-year or record levels in October 2007.

This was in the quarter that NBER now identifies as the start of the last recession. At the time however, the market was "predicting" that all was well. Further, does anyone recall the glowing earnings estimates that existed (and in fact were widely held) for 2008? It was only gradually, grudgingly and belatedly that these estimates were reduced.

Summing up, I believe it is still quite possible that our recent multi-week rally could resume and climb higher into year-end. It may not, but it could. Looking out past the next couple of months though, I believe that it is likely that we will enter a major downtrend.

Since my crystal ball is still in the shop (I need to find a new repair service) I do not think we should rely heavily on my prognostications. Instead we must remain flexible and trade the market we get.

For today that means looking for a bounce and attempting to determine how far it might carry. If it seems it could last for awhile, I may want to sell more of my bearish positions and/or add to my bullish ones.

Next up, let me say that I am about as far from a commodities expect as one can get.

With that caveat, I call your attention to 3 commodity charts I have seen this morning in the Investors Business Daily: Lumber, Crude Oil and Copper.

Crude oil is up near $100 per barrel. It did pull back yesterday, but it is still within shouting distance of that notable level. It does not seem to be closely following the movement of the Euro, Pound, Yen or Dollar Index so the rise seems to be more than just an adjustment of the price for currency changes. It would seem to this novice that the price would drop on a combined global recession which cuts demand and a "flight to safety" rise in the dollar which would lower the currency adjusted price. Until it does drop, if that even happens, won't the elevated price lead to higher gasoline prices in the U.S? Won't that be another dampening factor on consumer spending? If so, isn't that a bad thing for the U.S. economy?

Copper is affected by global factors but it seems to be rolling over and could be headed back to its recent lows. Is that also a warning sign regarding the global economy?

Finally, lumber is hitting new lows for at least the past several months. It would seem that is not a good sign for the home building industry specifically and perhaps for construction in general.

I will repeat that I am far from a