Change of Heart. Reduce Risk and Exit Calls. The Next Few Days Could Be Bumpy

March 12, 2014
Author: Peter Stolcers, Founder of OneOption

I’ve been expecting a soft patch after the extreme bullish sentiment last week, but the price action is concerning. The selling has been steady and the market feels like it is transitioning. That means choppy trading lies ahead.

A five-year bull run is very hard to turn. In the early stages of a trend change, the market attempts to make new highs and it hits heavy resistance. Eventually, it makes a series of lower highs and key support levels are breached. We are not at that stage yet and it is foolish to pick a top.

That said, I believe this is a time to reduce your size. There will be moments when cash is king. Discipline will determine your success this year.

You know from my comments that macro conditions are bullish. Europe is recovering, US consumers will unleash pent-up demand as temperatures rise, Obamacare and the debt ceiling have been extended, corporate profits are robust and buybacks are pushing stocks higher.

Everything looks great on the surface, but we need to be ever mindful of the undertow. Global debt levels are extreme and deficit spending is off the charts. As long as central banks support each other, this Ponzi scheme can continue.

Predicting a credit crisis is easy, pin-pointing the timing is virtually impossible. Anyone shorting the market in the last five years has been carried out in a body bag.

One thing I have learned over the last 25-years is that there is an information gap. The smart money has insight that the rest of us don’t. They will be the first to adjust positions and we will be able to pick that up using technical analysis.

In October 2007, everything looked great. We were poised for a year-end rally and stocks made a new all-time high. The market declined into year-end and that was unusual. In January, key support levels failed and that was a warning sign.

I am not suggesting that a credit crisis is about to unfold. We will let the technicals tell us when to get short.

I am mentioning this at great length this morning because Asia is getting great deal of attention. A few weeks ago China had its first investment trust default. Many analysts believe that hyper-growth and easy credit has led to massive over-expansion. Their shadow banking (unregulated financial institutions) rivals their banking system. No one knows the true risk exposure because these firms are unregulated. Economic conditions continue to slip and that will lead to higher non-performing loans.

You don’t hear much about Japan. Their debt levels are 200% greater than GDP. They have thrown the kitchen sink at their economy (Abenomics) and they have devalued the Yen. Unfortunately, they have not seen an increase in exports. If interest rates on 10-year bonds go to 2%, they won’t be able to cover their interest expense (dire situation). This is the third largest economy in the world and I believe it will be the first major domino to fall.

Central banks have printed so much money that it no longer stimulates economic growth. At best, it sustains the current level of activity. The Fed knows this and they are trying to gradually wean from QE.

I am not predicting a credit crisis. I mentioned this because we need to be ever mindful of the threat. The decline in January was unusual. Stocks bounced back immediately, but resistance is very strong.

This will be a much more challenging year. There will be times when we can spread our wings (i.e. the capitulation low), but most of the time we need to trade small size. There will also be times when cash is king. Discipline will determine your success this year.

China will release retail sales and IP tomorrow. The number is likely to be soft and investors will get spooked. The next hurdle comes Sunday. The Crimea will hold a vote and it is likely to be annexed to Russia. This will spark unrest. If $185 is breached, the market will decline

I did not like the decline yesterday and I sense trouble ahead. I am selling my call positions today and I will take my lumps. I just started scaling in on Friday so the losses are small.

I think it’s best to wait this one out on the sidelines. If support at SPY $185 holds next week, I will buy a few calls, but my position will be small.

If support is breached, I will buy puts. My position will also be small.

You should reduce risk into this rally. I don’t think we will challenge SPY $189 this week and the next few days could be bumpy.

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