Rally Feels Tired. Wait For the ECB’s Statement. Weakness In China Is An Issue.

September 5, 2012
Author: Peter Stolcers, Founder of OneOption

The summer doldrums should finally be over. Traders are bracing themselves for economic releases and for statements from the ECB.

Tomorrow, the ECB will release statements after its rate setting meeting. Draghi will also discuss sovereign bond purchases. The market was weak this morning and it snapped back on rumors that the purchases would be limitless. Yesterday, rumors circulated that the ECB feels it can purchase bonds up to three years in duration without violating any rules. This is greater than the 1 to 2 years the market expected and the rumors had a positive effect. Needless to say, expectations are very high.

The ECB is also drafting plans for a centralized banking system. That process is well underway and traders want to know when the blueprint will be finished.

A few weeks ago, Draghi made grandiose promises and the market gave him a “free pass”. Interest rates in Italy and Spain were spiking and he had to say something. Lip service will no longer satisfy the market and if details are not provided Thursday morning, the market will sell off.

Conditions in Greece are deteriorating and the likelihood of a default increases with each passing month. Spanish banks are on the ropes and capital outflows are steady. They are asking the ECB to lower collateral standards so that they can pledge their “junk” in exchange for cash.

The ECB tried LTRO but European banks did not buy sovereign debt. This is a sign of weakness and they had to go to “Plan B.”. The EFSF will be the buyer of last resort.

Problems are also brewing in Asia. China’s stock market is making four year lows and the PMI’s were dismal this week. I believe the economic contraction is severe and the PBOC won’t be able to prevent a hard landing. This could be the catalyst for the next market decline. China has been the global growth engine and this downturn will impact every major economy.

Initial jobless claims have been steady the last month and I believe the jobs numbers (ADP, initial claims and the Unemployment Report) will be benign. ISM manufacturing came in weak yesterday, but ISM services should be in line tomorrow. The primary focus will be on the ECB’s statements.

Overnight, FedEx warned. It is considered to be an economic barometer. They lowered their earnings range by 10% and cited global economic weakness. Next Tuesday, Texas Instruments and a number of other companies will provide mid-quarter guidance. Cautious statements could spark selling.

The best case scenario for the market would be unlimited sovereign bond purchases by the ECB (not likely). Even if they played that card, I feel this market rally is in its final stages. Asset Managers won’t chase stocks ahead of the November elections and the fiscal cliffs (US and Japan).

Traders won’t short the market when it is near four year highs and that is why it has been able to tread water the last few weeks. They will wait for the ECB’s statement and if it does not knock the cover off the ball, they will take bearish positions.

Given the PMI’s this week, analysts believe that the EU’s GDP could decline .5% in Q3. A number of analysts believe that the fiscal cliff in the US could result in a 5% decline in US GDP next year if the entire plan is executed.

I am buying October at the money calls on VXX and SPY in a 4:1 ratio. I outlined the strategy yesterday and I am using it as a hedged way to play a market decline. I am mainly staying on the sidelines and I will take bearish positions if the SPY breaks below $140. I will add aggressively if the SPY closes below $138.

Like every other trader, I need clarity. I will evaluate the ECB’s statement and I will gauge the market’s reaction. I will also be watching yields in Italy and Spain.

On a side note, European banks are trying to figure out ways to pass money market costs on to customers. European short term interest rates are negative and it costs the banks money to sit on cash. If this isn’t a warning sign, I don’t know what is. People will start pulling money out to avoid these charges and deposits will drop.

Look for normal trading to resume after tomorrow and be ready to take action. Keep your positions small today and look for choppy, rumor driven-price action.

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