What exactly is the life expectancy of last week's Thursday/Friday rally?

07/30/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

No secret what the big events that investors will hang on this week: The Federal Reserve’s Open Market Committee meets on Wednesday, August 1, and the European Central Bank meets on Thursday, August 2.

Will the Fed launch a new program of debt buying—a third round of quantitative easing? Will the European Central Bank cut its benchmark interest rate a third time—to 0.5%? Will it re-launch its program of buying Italian and Spanish government bonds? Will there be another big loan offering to European banks?

As hard as predicting what the central banks will do is, it’s just as critical and just as difficult to predict how the financial markets will react to action or non-action.

I still think that the most likely scenario this week is for the Federal Reserve to do nothing—but to tee up action for the central bank’s September 13 meeting with a statement that stresses the worryingly weak growth indicators for the U.S. economy and the very low rate of inflation in the United States. I think the Fed remains reluctant to act before the European Central Bank does—even if only by a day. The weakness is the global economy is largely a function of the euro debt crisis, the Fed has intimated, and I think the U.S. central bank would like its European counterpart to show some leadership right now.

ECB president Marie Draghi spent much of last week consulting with European leaders—Merkel and Hollande—and with Jenns Weidmann, president of the Bundesbank—and it would be a huge surprise if after that public consultation the European Central Bank did nothing. The question is how far Draghi will go—I think the odds favor another interest rate cut and a resumption of bond buying—with lesser odds in favor of a new round of money for Europe’s banks.

If events actually come out somewhere near my scenario, what will financial markets do?

The answer to that really depends on how traders are positioned after last week’s rally in global stocks. The rally is an indication that traders who had been short the euro, and Italian and Spanish debt, and global stocks (especially European stocks) bought those assets in order to move to neutral positions.

I think there’s a good likelihood that these traders will move fairly quickly after the central bank action to put those shorts back on. Nothing the central banks can do will really change the dynamics of the deteriorating economies of Europe that are currently locked into a downward spiral of more austerity and less revenue and bigger budget cuts and less economic growth. Traders also know that the Greek crisis, pushed out of the headlines by the Spanish crisis, has moved closer to a confrontation between the Greek government and the country’s funders over the minimal progress the country has made to fulfill the promises it made as part of the last bailout package.

But traders don’t make up the entire market and there’s some suggestion that investors with somewhat longer time horizons than a few days were wrong-footed by last week’s rally. Investors in U.S. equity funds withdrew $11.5 billion in the week that ended on Tuesday, July 24. That was the largest outflow of funds in two years, according to Lipper’s fund flows data. Much of that came out of ETFs (exchange traded funds) that track the Standard & Poor’s 500 index. Almost $6 billion, for example, came out of State Street’s SPDR S&P 500 ETF (SPY.) That pattern of outflows makes it likely that the investors betting that stocks would continue to fall were institutions, since those investors, rather than individual investors, use the S&P ETFs to register changes in their enthusiasm for equities.

Some of the money that moved out of stocks in the week that ended on July 24 certainly didn’t get back into the market in time to catch the rally on Thursday and Friday on Draghi’s pledge to defend the euro.

If that money decides to quickly reverse direction and get back into stocks in anticipation of the central banks’ decisions on Wednesday and Thursday, it could well balance any quick outflow of cash from traders after the banks’ meetings. The market action today and Tuesday will give us some indication of how this slightly longer-term money is thinking. If global equities climb strongly on Monday and Tuesday, it will be an indication that some of the institutional money that moved out of stocks a week earlier has decided to move back in. These investors are less likely than traders to reverse course quickly after Wednesday and Thursday’s decisions.

Which is not to say that this is patient or long-term money.

Strong flows on today and Tuesday, though, could indicate that the market will wait some days before reversing any rally.

We might be looking at a upwards move that could last a week or ten days (be still my heart) from its Thursday July 26 beginning.

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