ECB Band-Aids Won’t Lead To A Sustained Rally. At Best We Will Challenge SPY $142

July 31, 2012
Author: Peter Stolcers, Founder of OneOption

After a big run-up Thursday and Friday, stocks took a breather yesterday. The action will be muted today as traders square up ahead of major news events. Tomorrow, ADP employment will set the tone. Analysts are expecting 125,000 new private sector jobs in July. Corporations have been reporting light revenues and they are preserving the bottom line through cost cutting. I believe that payroll costs and hiring were tightly controlled. If the number comes in under 100,000, the market will have a negative reaction. ISM manufacturing will be released after the open and the consensus estimate is 49. This is the first time in the last year that it will have fallen into contraction territory. Tomorrow afternoon, the FOMC will release its statement. Ben Bernanke's rhetoric was a bit more "dovish" when he testified before Congress two weeks ago and traders are expecting QE3 in September. Central banks around the world have eased and that will put pressure on the Fed. As soon as QE3 becomes a certainty, the market will be looking for its next "fix". The Fed knows this and I believe that the rhetoric will keep traders guessing tomorrow. The release could have slightly negative impact. Thursday morning, official PMI's will be released. Europe will be extremely weak and traders will be watching China. China’s flash PMI last week was slightly better than expected. Initial jobless claims will be released before the open and they could be skewed by seasonal adjustments (auto workers). The primary focus will be the ECB. Economists are weighing in on all of the possible actions. The most likely outcome is that LTRO3 is scheduled to take place in the next few months. I feel that action will have a very temporary effect. The ECB will lower collateral standards so that European banks have assets to pledge. In theory, the banks will use this money to purchase sovereign debt. We have already seen two rounds of LTRO and Spanish/Italian yields continue to climb. European banks have sovereign debt coming out of their ears and they will simply use the cash to beef up their balance sheets. This "solution" will not work and the concept has lost its luster. The market could rally on the news, but the move won’t have “legs”. We could simply hear that the EFSF/SMP will purchase bonds. Under this plan, the ECB would not lend money to the EFSF/SMP, they would simply let them use their trading desk. In any event, the EFSF/SMP continually needs funding from EU members. Many are growing tired of the bailouts. Ironically, the countries that are in trouble have to contribute. The ECB President did not provide any details last week. Personally, I believe he just wanted to "stop the bleeding". The fourth-largest country in EU was in dire straits and yields had climbed above 7.5%. Shorts were overly aggressive and this statement sent them running for cover. If nothing else, Draghi's maneuver bought the EU a little time. I don't believe he has a grand plan. Last October, the ECB said that they were going to announce a "Grand Plan". The market rallied on the news and waited patiently. Economists dreamed up countless scenarios and the actual announcement fell flat on its face. The market heard the same old stuff and it sold off. Last week’s statement was just a ploy to buy time. In order to forge anything meaningful, Merkel needs to be involved and she has been on vacation. Fiscal reform would be much more meaningful than money printing. In November, Eurocrats promised to forge fiscal spending policies and to add them to the EU treaty by March. Here we are six months after the deadline and you don't hear a single word about fiscal reform. Eventually, the market will grow tired of promises. It's impossible to predict how the market will react. LTRO3 and EFSF/SMP purchases are simply Band-Aids. A centralized bank regulator and/or fiscal reform are meaningful actions, but they are blank promises with timelines in the distant future. Regardless of the market's initial reaction, conditions have changed over the last six months. It's not just Europe any longer. Economic growth in China and the US are deteriorating. Earnings guidance is cautious and corporations are hitting the bottom line through cost cutting. Most of the "pop" from earnings season has passed now that we are beyond the halfway point. The November elections are approaching and so is the "fiscal cliff". The market has plenty to worry about. Even if stocks hold up Thursday, a weak Unemployment Report on Friday could be a "splash of cold water". Analysts are expecting 100,000 new jobs. There are seasonal adjustments so the number could show more jobs than there actually are. Even with the buffer, I feel we will be lucky to hit 100K. If the jobs number is weak and the ECB tells us what we already know, we could see a nasty decline. Speculators rushed in last Friday and a close below SPY $138 could result in a round of selling. The market could give the ECB a pass and the jobs number might be acceptable. In that event, the market will continue to rally. My approach remains the same. I don't want to trade the long side. I see too many dark clouds ahead and I want to short the first reversal. I will buy puts if the SPY trades below $138 and I will add if it trades below $136. Option implied volatilities are at multi-year lows and I will also add to VXX/VIXY September call positions if we break those support levels. Look for a quiet day. No one will stick their neck out ahead of major news. Traders will square up and the market will trade in a tight range today. I do believe that shorts were hurt badly last Friday. There is more fear to go short than there is to go long. PMI's will be inline and ADP will set the tone. . . image

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