Stocks Are Quiet While Currencies Scream

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After a down January, the stock market is again positive for the year. The much-fabled January effect barometer didn't work in 2009, and it remains to be seen if it will work in 2010. Economic data has continued its slow improvement, keeping stocks fairly calm. The wild action so far this year has been in the currency markets.

The euro (still) has a long way to fall
I've been looking for the euro to fall for some time, and recent events in Europe, particularly the crisis in Greece, pushed the currency down sharply against the dollar and other major currencies. Even though much of the focus over the past year has been on the weak dollar, given large government stimulus spending and budget deficits, the fundamental conditions of the euro have likewise been deteriorating for a long time -- even if markets took their time in coming to realize it.

The main issue against the euro is that despite there being a single European central bank, each member country still has its own Treasury department. That means that although the European central bank can craft a unified monetary policy throughout the region, fiscal policies remain different among the various countries that use the euro. These discrepancies between fiscal and monetary policy create tension in certain countries and increases the fragility of the euro system as a whole.

In addition, it's becoming increasingly clear that some countries are running high budget deficits, having used questionable methods to hide their magnitude. The EU pact limits budget deficits to 3% of GDP, but many countries are currently over that limit. Greece's deficit, for instance, is running at 12.7% -- yet it was reported at much lower levels just a few short months ago.

The interesting impact here is that with the euro weakening, it's possible that the much-hated dollar, even-more-hated U.S. bonds, and the red-hot gold market could go up at the same time, breaking all historic relationships. When you look at gold prices in U.S. dollars, it appears that gold has been consolidating last year's gains over the past couple of months. But gold has been making all-time highs in euro terms, clearly suggesting that the euro is the paper currency with weaker fundamentals. That makes it more likely that European investors will look for protection against currency devaluation by investing in gold, making investments like SPDR Gold Shares (NYSE: GLD  ) and Market Vectors Gold Miners (NYSE: GDX  ) more attractive.

In addition, Treasury bonds, which have seen prices drop lately, might rebound if money leaves the weak European currency and even weaker European bond markets. The iShares 20+Year Treasury Bond ETF (NYSE: TLT  ) stand to gain the most if long-term rates fall. The deficit situation in the U.S. is not sustainable over the long haul, but if the euro continues to sharply depreciate in 2010, Treasury bonds may end up having a great year.

Banks are the key to 2010
With a few exceptions, most market sectors have been relatively flat so far this year. Telecoms and utilities have seen substantial drops, but gains in industrial stocks reflect optimism about the economy.

Even though financials have only modest gains for the year, I continue to view the sector as the most important one for the U.S. stock market. In particular, investment firms like Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) have seen their stocks perform weakly, which is a worrisome sign. During the bear market, these stocks acted as a leading indicator for the stock market, as they strengthened well before the overall market bottomed in March 2009. Yet both Goldman and Morgan Stanley hit highs last October and have languished ever since. It is true that there is a regulatory backlash against proprietary trading, and if the proposed Volcker Rule passes in its strongest form, it could hurt the long-term profitability of these companies for the benefit of the financial system.

Still, financials are enjoying some nice tailwinds right now. We are operating in an extremely steep yield curve environment, which allows banks to borrow from the Fed nearly interest-free and lend that money back to the U.S. government by buying Treasuries at significantly higher rates. This creates an interesting symbiotic relationship, where the central bank does not directly buy government bonds but instead lets the commercial banks use electronically created fed funds to buy more electronically created Treasury bonds from the primary dealer community. The government gets its financing, the primary dealers get their cut and the commercial banks pocket the yield spread. Is this sustainable at times of record deficits? The next few years should be revealing in that regard.

The key to the health of the banking system remain the commercial and residential real estate markets, which have yet to show significant signs of improvement. Warren Buffett recently said that he thinks housing should improve in 2011. That optimism hasn't brought major gains to homebuilder stocks like Toll Brothers (NYSE: TOL  ) and Pulte Homes (NYSE: PHM  ) , but some related businesses that depend on real estate activity have seen their stocks advance during the rally. If housing can put in a convincing bottom, it should bring renewed confidence about the economy as a whole. That's something we haven't seen in a long time.

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Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.

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