ECB Supplies A Put For the Market. Look For A Trading Range To Set In. SPY $133 – $138

August 2, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

The moment of truth is upon us and the ECB President has spoken. The ECB will facilitate short-term sovereign bond auctions through the EFSF. The purchases will be fully disclosed and the remaining logistics will be revealed in coming weeks. After the announcement, the S&P 500 declined 15 points.

This plan will reduce short-term borrowing rates for PIIGS and that might provide temporary relief. I like this solution better than LTRO3 because European banks won’t willingly participate in sovereign bond auctions. They are up to their eyeballs in PIIGS debt and they don’t want to add additional risk.

The problem is that interest rates will artificially be suppressed. Investors will have little appetite for these bonds because of structural deficits. Spain and Italy will continually issue new bonds to cover expenses and the maturities will be shorter and shorter. We might see some institutional buying inside of the three-year window. They will take comfort knowing that the EFSF will be there to support the auctions.

This solution is nothing more than a Band-Aid. Eventually, the EFSF will become the buyer of last resort and EU members (strong and weak) will continually have to fund it. At some point, strong nations will insist on fiscal reform and that’s when the entire union could fall apart. Finland is already threatening to pull out of the EU.

In the short run, this could stabilize interest rates in Italy and Spain. That would ease credit concerns for a month or two. Stocks declined on the news because this was not a major move by the ECB. The details are very sketchy and Draghi’s comments last week were lip service. I don’t blame the man, but I suspected as much. With Spanish interest rates above 7.5% he had to say something.

Yesterday, the FOMC did not give the market what it wanted to hear. There was no timeline for QE3 and stocks declined after the statement.

Wednesday morning, ADP employment came in better than expected. In July, 163,000 new jobs were created in the private sector. That was much better than the 125,000 jobs analysts were looking for. This morning initial claims came in at 365,000. That is a decent number, but it could be understated because of seasonal adjustments. Challenger Gray & Christmas reported that planned layoffs decreased 1.9% from June to July. This is a good sign and the levels are lower than they were a year ago.

The Unemployment Report will be released tomorrow and analysts are expecting 100,000 new jobs in July. I believe the number will be decent. Initial claims have been decreasing (seasonal adjustments), ADP was better than expected and Challenger Gray & Christmas reported fewer planned layoffs. Even though we might hit estimates, it is still a weak number. We need 250,000 new jobs just to keep up with labor force growth and we’ve only hit that level twice this year.

Even though Draghi’s statement fell short of expectations, I don’t believe it’s time to short this market. A temporary bid for Italian and Spanish bond markets will go a long way. The Fed is saving its last bullet and China said that it is ready to ease. At any moment, additional central bank action could spark a rally. Once these moves have been announced and the rally loses its momentum, I believe we have a chance to rollover.

The economic news (Chicago PMI, ISM manufacturing, Europe/China PMIs, GDP and ADP) has not been dire. If conditions slip, central banks will step in.

Earnings were good, but revenue growth is slowing down. Most companies have reported and the market won’t have this crutch.

Unfortunately, I believe we will muddle around for a few weeks. Now that earnings season is winding down, the focus will be on economic releases and interest rates. Central banks will provide a bid for the market and the sell-offs will be relatively contained. November elections and the fiscal cliff are still too far off.

If you are long puts, I suggest getting out of short positions. My focus has shifted. I bought some VXX/VIXY calls yesterday and I might sell some of them today. I still believe that option implied volatilities are extremely low and that they won’t decline much even if the market rallies. I may sell some out of the money put credit spreads today. I will keep my exposure very minimal. If the market does decline, my
VXX/VIXY calls will protect me. If we drop down to the SPY $136 level, I would be a little more interested in selling puts because premiums will expand. There is not much reward at this stage.

Any decline today will reflect disappointment in the ECB. The expectations were too high in the first place. Yields in Spain and Italy are up a little, but they should stabilize.

I hate quiet, directionless markets. Unfortunately, I believe that’s what we will see. Look for a range between SPY $133 and $138. Based on this range, you can see that I have a slightly negative bias. I needed to see the reaction to the news and now I know how to position myself.

After the Unemployment Report tomorrow, the action will slow down dramatically. This is a good opportunity to take time off.
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