The world’s stock markets increasingly are interrelated, and trader expectations, which drive most short-term price action, are shaped continuously by the nonstop torrent of global news flow. Americans no longer can afford to ignore what is going on in overseas markets.
Out of all foreign markets, major European indexes easily have the biggest impact on U.S. share prices. Europe’s crisis of confidence, ignited by its excessive government spending, has made it the primary focus of worry in recent years. Profligate European countries’ sovereign-debt woes increasingly have dominated traders’ attention.
But over the long run, geography is even more important. As the world rotates, the European markets are the last to experience the trading day before the U.S. markets open. Those critical couple of hours often set the tone of the U.S. trading day, highlighted first by futures traders who react to European news before U.S. cash markets open.
This is particularly true for sparking U.S. sell offs; fear is a contagious motivator. We saw a great example on March 6, one of the biggest down days of the year for the American flagship S&P 500 stock index, which lost 1.5%. The impetus was fear that Greece would fail to reach an agreement with its private bondholders. European stocks were reeling, with the German market down 3% and the French market down 3.6%.
Reviewing performance since 2010, a major percentage of big down days in U.S. stocks is preceded by weakness in major European indexes. American speculators cannot ignore what is happening in Europe.
European players
The big three European stock markets are in Germany, France and the United Kingdom. In 2010, these powerhouses represented 20.4%, 17.0% and 13.8% of total European gross domestic product, respectively. In population terms, they weigh in at 16.3%, 13.1% and 12.4%.
Germany’s flagship stock index is the Deutscher Aktien Index (DAX), which has the unimaginative utilitarian translation of “German stock index.” It represents the 30 largest German companies in terms of market capitalization and trading volume, but unlike the U.S. Dow Jones Industrial Average, it uses market-capitalization weighting (like the S&P 500). It began in 1987 with a base value of 1000.
France’s equivalent is known as the Cotation Assistée en Continu (CAC) 40, which means “continuous assisted quotation.” It tracks the 40 most significant French companies out of the 100 highest market capitalizations trading on the Paris stock exchange. The CAC 40 also is market-cap weighted, with about half of the shares of its component companies owned by foreign investors.
The United Kingdom’s flagship stock index is called the Financial Times Stock Exchange (FTSE), an acronym derived from its two parent companies, the Financial Times and the London Stock Exchange. Its components are the 100 largest companies in market-cap terms listed on the London Stock Exchange. These behemoths collectively represent more than four-fifths of the entire market capitalization of the exchange.
Comparing these dominant European stock indexes to the S&P 500 (SPX) offers many valuable insights. By examining recent long-term trends, we’ll see how these relationships work. In all accompanying charts, the markets are re-indexed to a common base of 100 where indicated so their fluctuations are comparable.
The Euro Stoxx 50, a compilation of the 50 largest companies in the Eurozone, has taken over as the Eurozone benchmark equity index and several of its components are included in these older European indexes.
History lesson
European stock markets weathered the same cyclical stock bear from mid-2007 to early 2009 that U.S. indexes experienced. In “Index comparison: January 2007-March 2009” (below) the markets are indexed off the preceding SPX cyclical bull’s top in October 2007. While the FTSE’s performance was a bit better and France’s a bit worse, all these lines are essentially interchangeable.
The major European stock indexes plummeted during late 2008’s epic stock panic, as well. It was truly a global event. Even after that incredible fear super storm, all the indexes ground lower to secondary lows in early 2009, and their total cyclical-bear losses were quite similar. The CAC 40 lost 59.2%, the SPX 56.8%, the DAX 54.8% and the FTSE 100 47.8%. Europe and the United States traded like one singular market during the last cyclical bear.
This highly correlated affinity continued into the subsequent cyclical bull, which was born in March 2009 and persists to this day. “Index comparison: January 2009-March 2011” (below) re-indexes each country’s leading stock index to 100 on the day the SPX bottomed, its bear low. While early performance was similar, by mid-2010 there were some definite performance divergences opening up in the various national stock markets.
As the European sovereign debt crisis deepened in spring 2010 — around the time of the first €110 billion Greece bailout — the indexes’ performances began to diverge. While the markets experienced their first collective cyclical bull correction then, France’s and Britain’s sell offs were more severe. The CAC 40’s drop made sense given French banks’ huge exposure to sovereign debt, but a similar fundamental explanation was lacking for the FTSE’s weakness.
While the SPX weathered a sharp correction as well, it had been the best performer prior to the drop, meaning its selling started from a higher level. Thus, its drop looked and felt more moderate than the CAC 40 and FTSE 100 plunges. Germany, as Europe’s strongest economy with the least relative sovereign-debt exposure, corrected the least and the DAX’s swoon was modest.
Since that first correction, the United States and Germany have been the best performers by far. France slowly recovered from that correction as worries about its banks’ sovereign-debt holdings persisted, barely hitting new to-date highs. And the United Kingdom, now fighting growing government overspending problems of its own, settled into a similar under-performing pattern between mid-2010 and mid-2011.
By their respective peaks early last year, the DAX and SPX enjoyed commanding leads with 105.3% and 101.6% gains. Lagging a full 30 to 40 percentage points behind were the FTSE 100 and CAC 40, at just 73.4% and 65.0%. These growing divergences were important, because indexes with smaller gains ought to have corrected less in this cyclical bull’s second correction.
Corrective divergences
These first two charts provide the necessary context to interpret the recent European stock action, starting with this cyclical bull’s second correction in late summer 2011. In “Index comparison: January 2011-March 2012” (below), the 100 base is advanced to the SPX’s interim high in late April 2011. The growing divergence in performances ballooned to different losses in this major selling event.
Once again, France led the way in this correction, falling rather steeply in July 2011 while the other indexes gradually ground lower. Rather ironically given all the focus on European sovereign debt, it was American overspending that sparked most of this correction. The trading day after the first downgrade of U.S. Treasuries in history, the SPX plummeted 6.7% and sucked the world’s markets into a new fear maelstrom.
Provocatively, the SPX bottomed immediately, carving a low that day that would only marginally fail for a single trading day eight weeks later in early October. Given how the SPX was one of the top performers in the cyclical bull before this correction, its resilience was impressive. Interestingly, the FTSE 100 started mirroring it and ignoring the rest of Europe. This relative U.K. strength made some sense given its underperformance in this bull; it didn’t have as far to fall.
As plunging stock markets ramped up fear, traders’ attention quickly drifted from Washington’s unprecedented downgrade to settle back on Europe. Whenever the U.S. stock market is weak, a dynamic emerges that hammers Europe. A weak SPX leads to dollar safe-haven buying, and the rallying dollar weighs on the euro. As the euro falls, traders increasingly get worried about Europe’s festering problems and dump European stocks.
So France and Germany got hit brutally hard in the latest correction. French banks had huge holdings of the sovereign debt of troubled European countries, including Greece. For a couple of weeks during that correction, rumored impending defaults of major French banks were big news in the American financial media, but Germany following suit was less logical.
As “Index comparison: January 2011-March 2012” shows, the DAX mirrored the CAC 40 almost perfectly in the recent correction. German banks were never in trouble, and German sovereign debt was the strongest in Europe. But there were lots of worries that the Eurozone would fracture. If that came to pass, then Germany’s huge export business would be crippled with the rest of Europe.
Likely, the main reason the DAX fell so hard was because it was up so high in its cyclical bull leading into that correction. Markets often exhibit considerable symmetry in major rallies and corrections. The bigger the preceding rally, the more extreme greed becomes, so the bigger the subsequent correction that is necessary to ignite enough fear to fully rebalance sentiment. Thus, Germany plunged.
This led to wildly different correction losses. The FTSE 100 and SPX saw 18.8% and 19.4% retreats, significant but under the classic 20% correction threshold. Meanwhile, the CAC 40 and DAX plummeted 33.1% and 32.6% respectively.
Recovery analysis
This brings us to current concerns. As the first two charts showed, U.S. markets can be influenced heavily by European ones and vice versa. Because France and Germany technically experienced new bear markets (20%+ declines), are they going to continue lower and drag down the SPX? Or are the European stock markets soon going to reenter their previous cyclical bulls?
Provocatively new bear fears were common among U.S. pundits in late September and early October. However, the SPX started powering higher again, eventually hitting new bull highs that proved last summer’s sharp sell-off was merely a healthy mid-bull correction and suggesting that the SPX is now leading. Though so far the SPX is the only major stock index to hit new cyclical bull highs, the European markets are catching up. The FTSE 100 has been mirroring the SPX, and doesn’t have to climb much to hit new highs of its own. And the DAX has been on a tear, surging back ahead of the CAC 40 in a dramatic comeback. New bull highs aren’t much of a stretch for German stocks either.
Viewed this way, France still is lagging, but this is somewhat misleading. Remember that all these charts re-index each stock index off of major highs and lows in the SPX. France’s losses during the recent correction were so steep and its preceding topping offset far enough from the SPX’s that it distorts its relative gains a bit. “Index comparison: July 2011-March 2012” (below) re-indexes everything from the SPX’s correction low.
With this perspective, France is not only catching up, but is pulling ahead of the United Kingdom. Though the United States led initially in terms of gains out of the correction, Germany has taken the lead. As of late March, the DAX’s gains were 39.6%. Meanwhile, the beleaguered CAC 40 actually is in second place at 28.1%, with the SPX not far behind at 27%. The FTSE 100 is the laggard at 20.5%.
All these gains are above 20%, the common metric to classify a new bull market. While the 20% move threshold for trend reversals does not always hold true, countless traders accept them as gospel. So even if someone wants to classify the recent brutal stock sell-offs in Germany and France as bear markets, by that same standard they are once again in powerful bulls.
What really happened in Europe was the same thing that happened in the States. A major cyclical bull was born in early 2009, and it has been punctuated by two major corrections. The latest one was incredibly extreme in Europe, but it was still merely a correction. Like the SPX, the DAX, CAC 40 and FTSE 100 remain in that same cyclical bull that was born soon after the stock panic. And also like the SPX, these major European stock indexes likely will achieve new bull highs.
Bright future
As we saw with the SPX in late February, new bull highs create a psychological boost. Greed gradually replaces fear, enticing sidelined capital hiding out in cash back into stocks. The shrill cacophony of new bear and recession fears that dominated discourse around the correction lows is forgotten. New bull highs dramatically alter sentiment, paving the way for big gains.
This sets the stage for major rallies in European stocks. So, instead of the American stock markets facing the usual stiff headwind from falling European markets, we increasingly are going to enjoy a serious tailwind.
The European stock market and economy in general have a major influence on our markets. During the recent correction, their weak behavior often weighed on the SPX. But despite all the intense fears then, the major European indexes have been recovering beautifully since. They may be on the verge of following in the SPX’s footsteps to achieve new cyclical-bull highs. Whether they continue to recover or slide back into a correction or bear market, it would be wise to follow what happens because it likely will be replicated here.
Adam Hamilton is an analyst for Zeal LLC. Contact him at www.zealllc.com.
