We sympathize with Germany's position in Europe. They understand it will be much more difficult to see over-extended budgets brought back into line after checks have been passed out (again). Germany's bargaining power remains strongest when bond market pressures are high in Italy and Spain. If your house is on fire, a guy with a bucket of water is in a good bargaining position.

The recent spike in Spanish and Italian bond yields has moved Germany's leverage into "playing with fire" territory. The Germans are living in fantasy land if they think their current path will calm bond market investors.

At the 13:27 mark of a popular December 2011 video, we explain why rising bond yields can create an unsustainable situation or crisis. In the long run, we believe Germany is taking the proper approach to create sustainable growth. However, as we noted on June 15, Germany's timetable is radically different from Wall Street's, which is where the fantasy land analogy applies.

Prior to the next in a long series of "make or break" summits, Europe looks like two rams competing for an attractive mate, rather than an united market-friendly union.

From Reuters:

European leaders sound unusually divided before a high-stakes summit, with Germany's Angela Merkel saying total debt liability would not be shared in her lifetime and giving little support to Italian and Spanish pleas for immediate crisis action.

Shortly after being appointed to lead Italy from the financial abyss, Mario Monti was dubbed "Super Mario" by the Italian press based on his ability to get things done. The Bloomberg excerpt below highlights why the bond market continues to shy away from Italian debt despite Monti's progress:

Unfortunately, Monti has inherited an accumulated public debt large enough -- at 120 percent of GDP -- to overwhelm his efforts to close the gap between current revenue and outlays. With investors' confidence rattled, the cost of rolling over the debt is becoming prohibitive. If the bond yield -- currently hovering around 6 percent, up from 4 percent two years ago -- stays high enough for long enough, the country will be insolvent.

Germany's current approach will most likely need to be supplemented with some less-than-desirable moves in order to get the burning bond market back under control. Reuters summarizes Italy's position heading into this week's meetings:

Monti said he would repeat his call for the European Financial Stability Facility and the European Stability Mechanism, the two funds set up to provide a "firewall" against the spreading debt crisis, to be used to help ease the pressure on Italian debt. Italy is proposing to use the funds to help limit the spreads over German Bunds on bonds issued by countries that respect EU budget rules. The proposal has run into stiff opposition from Germany, the largest economy in the European Union and the bloc's effective paymaster, and has been rejected by Jens Weidmann, the powerful head of the German central bank, the Bundesbank.

Spain and Italy are both under extreme funding stress. Therefore, it is not surprising they are pushing for similar assistance, which falls outside of Germany's comfort zone. From Reuters:

Spain is determined to retain access to market funding and will push for European institutions to use available options to stabilize financial markets, premier Mariano Rajoy said, maintaining his policy stance ahead of an EU summit.

To keep market expectations low, Angela Merkel restated Germany's position. From The Telegraph:

Ms Merkel told the German Parliament on Wednesday ahead of a European Union summit there is no "magic formula" that will make the crisis immediately go away. She insists that Europe must tackle its problems at the roots - which she says are a lack of competitiveness and high debts - in a step-by-step process. Ms Merkel says any other approach is condemned to failure. "It is imperative that we don't promise things that we cannot deliver and that we implement what we have agreed," Ms Merkel said to loud applause in the chamber. "Joint liability can only happen when sufficient controls are in place," she added.

Charles Dallara, managing director of the Institute of International Finance (IIF) and a key negotiator in the restructuring of Greece's debt, represents the view of large buyers of sovereign debt. From Reuters:

"This is about winning back the confidence of long-term oriented investors such as pension funds and insurance companies - and I fear that they will be convinced only by comprehensive solutions."

We often read that financial markets are addicted to stimulus and policy intervention, almost implying something is wrong with the markets. Unfortunately, the markets are acting in a very rational manner. Markets know the entire financial system has been propped up with deficit spending, printed money, manipulated interest rates, and taxpayer bailouts. For those who point to strong earnings and fundamentals, we invite you to answer these questions:

1. If the global economy was fundamentally sound, why have policymakers kept interest rates at near zero levels? Why are they willing to commit to keeping them low for a long period of time?
2. Why have historically low rates not sparked more growth or inflation?
3. What would growth and corporate profits have looked like without unprecedented global stimulus (spending money we do not have), money-printing, and near-zero interest rates?

The answers to many of the questions above relate to unhealthy balance sheets. As we outlined in an October 2010 video, rather than purging bad debts from the system, policymakers have attempted to repair the asset side of balance sheets. The process of "stimulating" asset prices works for a time, but the markets eventually come off their sugar high and realize no one wants to deal with the debt, with the exception of Germany. Germany is often cast as the hard-line villain in the media. The harsh reality is many debts around the globe must go through a restructuring process. It is and will continue to be very painful, but on the other side, confidence will return and sustainable growth will follow. We will have sluggish growth for a long time unless the debt is purged from the system.

Mario Monti has stated he is willing to work into Sunday night in an effort to make progress before the markets open on Monday. Therefore, investors hoping for some significant news this week may be disappointed. Our investment approach remains unchanged:

1. Remain flexible and nimble
2. Lower lows could be coming and may represent a buying opportunity
3. Have contingency plans for bullish and bearish outcomes

If key levels above 1,240 are breached on the S&P 500, a deflationary decline could move fairly rapidly toward 1,160, just as stocks moved rapidly in a bullish manner from 1,260 to 1,320 in early 2012. The bull/bear demarcation lines are outlined in a June 22 video. As shown below, from a short-term perspective, the bulls have made some progress.

Since some technical strings remain untied, the most difficult scenario to deal with from a probabilistic perspective is that stocks have already put in the low for 2012. This scenario will gain traction if the S&P 500 can close above 1,325 followed by 1,354.