Europe’s “Rigged Game” Could End
at Any Time and Send Stocks Reeling

By Dennis Slothower
Editor, Stealth Stocks

The panic selling paused Thursday as a new primary Italian bond auction successfully completed at a 6.8% yield, just under the dreaded unsustainable 7%, soothing the financial markets that perhaps Italy will not become another Greece after all.

The news from Europe was positive on Thursday, for a change. And having the jobless claims come in a little bit better as well didn’t hurt. But it was the Italian bond auction that halted the panic selling of Wednesday.

The headlines and news wires say that a billion euro bond auction in Italy went off without a hitch and managed to find buyers at only a 6.8% yield, compared to the high of 7.5% hit Wednesday. The euro strengthened on the news and the dollar weakened as stocks around the world bounced, though not much.

Let’s take a little closer look here. In the secondary market, similar Italian bonds are selling at 8% yield. No, not just similar bonds…exactly the same type bonds. Now if you were a hedge fund manager or a bond trader or a sovereign wealth fund or a bank and you had an opportunity to buy a certain bond that would bring 8% from one source or buy the same bond from the primary issuer for 6.8%, which would you buy, assuming prices were the same?

Only a fool would settle for 6.8% when you can get 8% around the corner. So what happened in Italy on Thursday? How did they manage to attract buyers at the 6.8% yield?

A lot of people are asking the same question, particularly since the ECB is prohibited from participating in primary bond auctions.

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Insider information and rumors strongly suggest that the ECB pulled a fast one here, perhaps negotiating with another buyer or buyers to buy the 6.8% bonds and then the ECB would either take them off their hands for a small fee or other assets at an adjusted margin between the 6.8% and the market 8% rate.

The Italian bond auction was backstopped by someone, either our own Fed or the ECB using some type of “scratch-my-back-I’ll-scratch-yours” deal. It worked on Thursday, in that the global markets paused their panic selling for a while. But it didn’t change the secondary market for Italian bonds.

The ECB can’t keep this up. They don’t have enough money or agreements in place to become the lender of only resort for all of the Italian bonds that will roll over month after month. It is believed that just under 400bn euro of bonds are needed for Italy to keep their government operating for the next 12 months.

Even the EFSF will never be big enough to keep this kind of tactic going.

Stocks Are Tied to Euro Apron Strings

The correlation between the euro and equity assets has become so tight, all one needs to do is follow the direction of the euro hour by hour to make equity purchase / sell decisions.

Notice how closely the S&P 500 has tracked the euro since the summer correction took place. There is a slight divergence occurring right now, though. The euro, while stopped in its downward slide a bit Thursday looks prepared to head down further, possibly to the lows seen at the first of October.

The S&P 500 is showing a little more bullish strength, though not much better than the euro.

So who is leading who here? Is the S&P 500 going to follow the euro down on further Eurozone chaos and contagion or is the S&P 500 going to pull the euro up by its bootstraps? And if you don’t know the answer to this question, you haven’t been following me closely the last few weeks.

Check out what the euro has done in the next chart…and what we are likely to see in the broader equity markets, as well:

I showed readers a chart of the euro / dollar relationship on Wednesday, pointing out the confirmed bearish head and shoulders pattern. Well, that same pattern exists for the euro by itself, as well – since there is virtually a 1:1 inverse relationship between the euro and the dollar.

Thursday’s pause in the equity sell off may be nothing more than the euro making a simple back test to the broken neckline of the bearish head and shoulders pattern. If this is the case, then the euro could easily continue to fall in the coming days. And remember that a fully played out bearish head and shoulders pattern would take the euro to the lows seen at the beginning of October.

This suggests that equities could take the very same path.

2011 / 2007 Deja’ Vu

I want you to closely study this next chart, especially the later part of 2007 through the collapse in 2008. Note the commonly circled areas and compare them to 2011. If this almost perfect pattern continues to follow the 2007 – 2008 path, then we are looking at a scenario that makes the October low potential pullback only the first of several declines ahead.

I have seldom seen a historical trading pattern repeated so precisely as 2011 is repeating the 2007 – 2008 timeframe. We will continue to follow this as long as the patterns continue to remain the same.

What About the SuperCommittee?

As you know, the upcoming SuperCommittee of 6 democrats and 6 republicans, have the task of coming up with at least $1.2 trillion in spending cuts or tax revenues to narrow the U.S. deficit. If they don’t succeed, then at least $1.2 trillion in cuts to defense spending and entitlement programs will take place…without a single congressional vote.

This plan needs to be completed by November 23^rd. And since the plan needs to be examined and priced out by the CBO, the bulk of the plan needs to be delivered to the CBO sometime next week.

This could get real interesting over the next two weeks.