QE3, CAT and BA Provide Small Rally – Fade It! A Sustained Decline Is Under Way.

July 25, 2012

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Yesterday, stocks probed for support and the market declined for the third straight session. Support at SPY $136 has been breached and the strongest companies have reported. The price action is very weak and I believe this is the beginning of a sustained decline.

The market had everything going for it last week and it barely managed to get through resistance. It should have been able to challenge SPY $140 and it never got close. That tells me Asset Managers were selling into strength.

The downward momentum was starting to accelerate yesterday and news leaked out from the Wall Street Journal that the Fed is getting ready for QE3. Is that really news? Chairman Bernanke said as much when he testified before Congress a week ago and the probability for easing in September increased dramatically. Central banks around the world have cut interest rates in the last two weeks and the Fed will be pressured to follow suit.

Buyers stepped in and the market rallied off of its lows. Unfortunately, QE3 won’t stimulate economic activity. Previous action has not helped and once the “fix” wears off, traders will be “Jonesing” for more. I believe the Fed knows that it’s almost out of bullets and it wants to dangle the carrot as long as possible.

This morning, Caterpillar and Boeing beat estimates and they provided upbeat guidance. Stocks are moving higher on the news and cyclicals are catching a bid. Unfortunately, this is nothing more than an oversold bounce. Not one Asset Manager feels like they will miss the next big move in cyclicals. These are two of the strongest companies and they tend to lead during economic recoveries. Conditions in Europe continue to deteriorate and that is spreading to the rest of the world. We are nowhere close to a recovery; we have not even seen the lows yet.

Apple is the largest company in the world and it missed earnings estimates. They will release a new product in coming weeks and consumers are postponing purchases until it is released. Weak conditions in Europe also contributed to the miss. This stock has been able to carry the market and the headwinds are starting to blow. As I mentioned yesterday, shorts will not get aggressive until Appleā€™s earnings release is behind us.

UPS is considered a barometer for economic activity. They missed earnings estimates and they lowered guidance. When transportation activity declines, it indicates soft demand across many different industries.

On Friday, Q2 GDP will be released. Estimates have been reduced and the consensus stands at 1.5%. This news will weigh on the market.

Credit conditions in Europe have reached the tipping point. Spain and Italy account for 20% of the EU’s GDP. They are too big to fail and too big to bail. Interest rates have spiked to new highs and bond auctions have gone poorly. National banks are “tapped out” and they won’t be supporting sovereign bond auctions in the future. This means the ECB, the IMF and foreign investors will have to pick up the slack. Rates will continue to climb.

Strong corporate balance sheets and attractive stock valuations are the best thing the market has going for it. We have gone through the strongest part of earnings season and now the reactions will be negative. More than three quarters of the companies have missed revenue estimates and they are only hitting the bottom line because of cost-cutting. That does not bode well for future jobs reports.

Next week, ADP, Challenger Gray & Christmas and the Unemployment Report will be released. Initial claims continue to grind higher and the numbers will be dismal. Official PMI’s will also be released and we will get ISM manufacturing and ISM services as well. Get ready for a weak round of economic news.

I told you earlier in the week that we might have to weather a few rallies. That is exactly what we are doing this morning. Each rally will fade faster than the previous one and these little “pops” will provide future entry points for bearish positions.

I am long puts from last week and I have a “full boat”. I have not had this much risk exposure in many months. My confidence is extremely high and I believe the market will drift lower throughout the day.

I am also long VXX/VIXY calls. One interesting note on trading implied volatility. Floor traders are taught to sell premium. They are especially aggressive when implied volatilities rise. Each time the market recovers, you will see an instant drop in implied volatility.

In order to make money on VXX calls you need a sustained move. Eventually, when premiums start to escalate, traders have to adjust and they buy the VXX/VIXY or they get long (buy back short option positions) index options or stock options. Premiums explode and you have a huge spike in IV. You have to have a lot of staying power to trade VXX calls. If I did not believe we were on the brink of a sustained market decline, I would not trade VXX/VIXY calls.

Today’s rally will fade quickly. The macro news from all corners is simply too weak and in a matter of days, traders will be searching for any shred of good news. As support levels fall, the selling pressure will intensify.

Look for opportunities to get short.
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