Europe's Rally Sets Stage for Flop

NEW YORK ( TheStreet) -- A temporary halt to short trading helped European markets rally on Friday, but a number of remaining red flags in the eurozone are likely to have a greater impact than the day-to-day whims of the market.

High Frequency Economics raised the alarm in a research note early Friday, urging investors to take a broader perspective on the situation in Europe.

"Stocks are up in Europe. Risk trades are coming out of the market -- Bund yields are up, and yields on Italian tens are under 5% and steady. However, scratch a little bit to see that things are not as calm as they appear."

HFE's Carl Weinberg writes that Italian bonds only appear stable because of interventions by the European Central Bank. The credit default swaps market, where the central bank does not interfere, "still prices default insurance on Italian bonds at or barely below record highs."

"People ignored problems in Europe that started much earlier this year," warns Phil Roth, chief technical analyst at Miller Tabak. The "crummy rally" in the second quarter of this year was a key precursor to this week's climatic sell off, he explains.

For true long-term investors, the direction of the market is bound to reflect global GDP. Growth in Greece contracted 2.8% from the first quarter and by High Frequency Economics's calculations, that translates into a more than 11% annualized contraction. A number that big is likely to affect the government's future efforts to reduce the fiscal deficit. HFE's stance is that "more trouble with Greece is inevitable."

The problems aren't confined to Europe. Next week, Japan will publish its second quarter GDP numbers. The country has already slashed its forecast because of a drop in consumer spending. Annualized growth starting from the second quarter is only estimated at 0.5%.

Also to come are GDP figures from the leading European economies next Tuesday. Second quarter GDP in the the Eurozone grew by an annualized 1% to 0.5%, estimates High Frequency Economics. "That means almost no quarter-to-quarter economic expansion!"

"Even though equities look steady, we fear the economic news could drive them back into a tailspin very quickly. Watch out," says HFE.

Already the stats coming out this morning have been negative. Industrial output in the euro area fell by 0.7% in June, according to a report by EuroStat. Second quarter GDP in France was flat, according to a report by the National Institute of Statistics and Economic Studies. Little growth is expected for the third quarter and a drop in consumer spending recently prompted research firm Capital Economics to cut its forecast for French growth this year from 2% to 1.5%.

Without a comprehensive strategy from European officials, the decay of Europe's fiscal condition continues. "People in fiscally healthy countries like Germany and Netherlands remain reluctant to see their tax money go to fiscal responsibility," says Francisco Torralba, economist at Morningstar Investment Management. Realization that the countries have to pool together their debt in order to stabilize the euro is growing but recent news reports suggest that debates lying ahead will be divisive.

History shows that banning short-selling may not work in the longer term. The S&P 500 crumbled when the U.S. banned shorting on financial stocks after the fall of Lehman Brothers in 2008. The index continued falling after the ban was lifted.

Analysts have warned again and again that developments in Europe will continue to plague the U.S. market. Putting too much stock in Europe's rally may prove a mistake.

-- Written by Chao Deng in New York.

>To contact the writer of this article, click here: Chao Deng.

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