The Check Is In the Mail and the ECB Will Take Decisive Action. Expect More Promises.

July 30, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Last Thursday and Friday, the market staged a massive rally. The SPY has broken out to a new relative high on heavy volume and it is bumping up against major resistance. Comments from the ECB sparked buying.

When the market believes that the ECB/EU is addressing credit issues, it rallies. We saw this in the fall of 2010 and in January this year. Stocks are attractively valued and Asset Managers desperately want to rotate out of fixed income and into equities. Bond yields are at historic lows and they are struggling to generate a return on their investments.

Unfortunately, the ECB President did not provide any details last week. He simply said, “We are ready to do what is necessary to avoid a financial collapse”. The fourth largest economy in the EU was on the ropes and interest rates in Spain were above 7.5%. What else would you expect him to say?

The ECB/EU will try to form a centralized banking system. That is no secret. There are many obstacles and this will take more than a year to form. I doubt any serious developments on this front will be discussed.

It is also possible that the SMP/EFSF will start buying sovereign debt. If this is the “big news”, it simply means that the ECB will lend its trading desk to the SMP/EFSF. The ECB will not lend these facilities any money and this news would be a major let down since the market is expecting something major. These facilities will continually need to raise money from EU members so that they can buy sovereign debt. Many member nations are already opposed to future bailouts and they don’t want to contribute.

LTRO3 would spark a rally, but the impact would be temporary. The ECB would first lower collateral standards so that European banks actually have assets to pledge. Then they would lend money to the banks for a three-year period. In theory, the banks would purchase sovereign debt. I have many issues with this solution.

First of all, the quality of the collateral keeps decreasing and European banks are pledging junk. Eventually, they will have to repurchase these assets and repay their loans. Banks are straddle with toxic sovereign debt and they won’t materially participate in sovereign debt auctions. Many banks simply used the loans to beef up balance sheets. We have already gone through LTRO1 and LTRO2, yet Spanish yields rose above 7.5%. Euro banks weren’t using the cash to buy Spain’s debt.

European banks are leverage 26:1 or more. That compares to 15:1 in the US. If Basel III were passed, 75% of all Euro banks would fail. I believe Italian and Spanish banks are “tapped out” and they won’t be participating in future sovereign bond auctions to any degree.

No matter how you slice it, fiscally responsible nations will have to support reckless spenders. In order to change the EU treaty, a unanimous vote is required. Patience is running thin.

Last September, the ECB said that it would announce its “Grand Plan” in October. The market rallied while it waited and huge expectations were built up. When the actual plan was revealed, the market sold off. The same could be true this week. The ECB will meet on Thursday and the market will wait with “baited breath”. I’m not expecting any material developments, but if Draghi promises something big in September or October, the market could continue to push higher.

Similarly, traders are expecting the Fed to launch QE3 in the next few months. The FOMC statement will be released Wednesday. Prior easing has not stimulated the economy and as soon as QE3 is launched, the market will be looking for QE4. This is a never-ending cycle and each round of easing has a smaller impact.

It’s not just about Europe at this juncture. Four or five months ago, it was all about Europe. Growth in China is slowing and conditions in the US are slipping as well. Corporate earnings were strong due to cost-cutting and 75% of the companies missed revenue estimates. Q3 guidance was weak. The November elections and the “fiscal cliff” are approaching. These factors will all weigh on the market.

Earnings season is more than half over and this week we will hear from the healthcare sector. With each passing day, the reaction to earnings releases will become less important. Good news is priced in.

This week we will get the official PMI’s, ISM manufacturing, ISM services, ADP employment, initial claims and the Unemployment Report. Corporations have been cost-cutting and I believe private sector job growth will be dismal. The consensus estimate is for 100K new jobs.

I am flat. I don’t have any positions and I am waiting for everything to play out. We will not get a master plan out of the ECB this week. Expect lip service and promises so that Eurocrats can enjoy their vacations without a market meltdown. All that matters is the market’s reaction. If traders believe that the ECB/EU will get ahead of the curve, we could blow through SPY $142. That’s unlikely, but possible.

A more likely scenario is that the Fed still holds off on QE3 and the ECB comes up light on details. Weak economic releases and a dismal jobs report will weigh on the market and stocks will retreat after challenging resistance. The earnings from this point on will also lack “pop”.

If the SPY breaks below $138, I will buy puts. If the SPY breaks below $136, I will add. As the market moves higher, my entry points will move higher. I want to catch the first reversal.

If the market continues to grind higher, it will do so without me. I only want to play the short side.

Stocks will try to grind higher into the FOMC statement. If you play the rally, keep your longs on a tight leash.
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