Over the last few weeks things have gotten worse in the European sovereign debt markets, yields for most Euro zone countries including France which is AAA have gone up. The EFSF which is the bailout fund is itself having trouble finding buyers. The situation seems to be getting out of control. Only some ECB intervention in the Italian markets has kept yields from going further higher. Over the last few weeks the S&P 500 has held up relatively well in light of these conditions. I think there are probably two main reasons for this.
1. A lot of active fund managers are sitting on cash and there are reports that many hedge funds are under performing the market this year. So in order to make up for performance before year-end some of this cash could be coming into the market and supporting the stock market.
2. I think the more important reason could be that the market is betting that ultimately Germany will give in and allow the ECB to announce a major bond buying program. At this stage it appears that the ECB is the only institution that has the resources to stop the crisis from getting worse. The ECB can potentially print unlimited amount of Euros and buy Euro debt, of course Europe will face potential of higher inflation. I think the recent divergence in the Euro and S&P 500 suggest that ECB intervention is what the market is counting on. ECB intervention would be bad for the Euro and good for equity markets. If you look at the chart below you can see that starting the first week of October the Euro has remained weak but the market has gone up.
I think the market might be getting too optimistic, I don’t think the ECB will come in with a major program until the situation gets much worse. The Germans are really paranoid about inflation and they will agree with this option only when things get really bad.