New 4-Year Highs. Absence of Selling – Market Will Grind Higher. Use Caution

August 21, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

There are days when it takes me hours to sift through the news – this is not one of them. Earnings season is winding down, European credit concerns have subsided and the economic releases are light. Politicians and traders are taking time off before their kids return to school.

The market is poised to make a new four-year high today. Stocks have been able to challenge resistance and the bid feels strong. Volume is the missing ingredient and anemic activity indicates a low-level of conviction. One bad news event could easily wipe out two weeks of gains.

Nothing has changed in Europe. The ECB was already supporting short-term sovereign bond auctions. They launched LTRO1 and LTRO2 with the hope that European banks would use the cash infusion to buy PIIGS debt. These financial institutions are already up to their eyeballs in sovereign debt and the plan did not work. Interest rates in Spain and Italy spiked a few weeks ago.

This dismal participation is a clear sign that the EFSF is the buyer of last resort. Some institutions will sponsor short-term bond auctions knowing that the EFSF is providing support. Long-term yields are elevated and sovereigns will finance their needs on the short end of the yield curve. All of their debt will get pushed forward and bills/notes will continually rollover.

In the future, one little pop in short term rates could be devastating. If institutions decide that they need to liquidate sovereign debt, all of the money in the EFSF won’t be enough to stop the bleeding.

Structural deficits caused by entitlement will plague PIIGS and the auctions will require an increasing amount of support. Member nations will continually add money to the EFSF and the dissention will grow.

As long as the market supports the ECB’s actions, stocks will rally. The centralized banking plan is being drafted and it will supposedly be reviewed in coming weeks. I don’t trust these promises and I expect the process to be delayed. We will be lucky to see a plan in 2012.

The market will wait patiently. Central banks are ready to ease and they are providing a backstop.

Stocks are attractively valued (forward P/E of 13) and balance sheets are strong. Asset Managers are anxious to rotate out of fixed income and into equities.

This market breakout will attract bullish speculators. Shorts have covered and I don’t believe we will see much of a squeeze. No one wants to “fight the Fed”. This absence of sellers has paved the way for this melt up.

The next big news event will come Thursday morning when flash PMI’s are released. If the numbers are better than feared, the market will rally. On the other hand, if conditions deteriorate, we will temporarily pull back. That dip will be a buying opportunity and bulls will expect central banks to take action.

I don’t see anything that will stand in the way of the rally this week. Volumes are light and caution is warranted.

I like buying stocks that have consolidated for a few months after moving higher and are breaking out to new relative highs. This pattern tends to produce sustained moves. I am keeping my positions relatively small and I am limiting overnight exposure.

Look for a quiet drift higher this week.
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