Buy Puts. This Is the Start of A Sustained Decline. Scale In and Short Any Bounces.

July 23, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Last Friday, I suggested exiting long positions and entering short positions. The price action was very telling and I suspected a substantial market decline was about to start.

Today, horizontal support at SPY $136 has been breached and that is also the 100-day moving average.

I have been anxious to take short positions, but I have been able to temper my bearishness during the first few weeks of earnings season. European credit concerns had temporarily subsided and the economic releases were light. Stocks had rallied above resistance and option expiration should have provided a positive influence. The table was set for a nice little rally.

The news last Thursday was generally bullish. Google and Microsoft posted excellent earnings and it looked like the rally would continue. Friday morning, stocks tested the downside and they drifted lower throughout the day. Strong corporate balance sheets and attractive valuations are the best things the market has going for it. When we didn’t get a rally off of decent “Mega Cap” earnings, the warning sirens started to blow.

As I mentioned last week, the market was treading on thin ice. Option implied volatilities had dropped to three year lows and that was a sign of complacency. Traders have become numb to European credit concern headlines and until today, they did not fear a selloff. The stakes could not be higher.

Italy and Spain comprise 20% of the EU’s GDP. Combined that is 10 times the size of Greece. Interest rates in Spain spiked above 7.5% on the 10-year this morning. This is considered by most analysts to be the point of no return. Default is getting priced in and it will be difficult for the country to sell bonds. I believe that Spanish/Italian banks are “tapped out”. That means they won’t participate in future sovereign bond auctions and the ECB, IMF and foreign investors will have to pick up the slack.

The bigger problem is that the ECB is out of Band-Aids (interest rates at 0%). Printing money is not the solution. Eurocrats have not addressed the problem during the last two years. Entitlement programs are sucking these countries dry and politicians aren’t willing to pass reforms. Austerity cuts are helpful, but they are insignificant relative to pension/healthcare costs.

In the next year, 100% of US tax receipts will be spent on entitlement (Social Security, Medicare and Medicaid) and interest on our national debt. That means that all the money spent on nondiscretionary expenses (defense, education, Department of Justice, homeland security, transportation, veteran affairs…) will continue to drag us further into debt each year. Those expenses currently run about $1.3T a year.

This story gets worse. “Baby boomers” are starting to retire. They won’t be paying into the system; they will be drawing from it in an exponential fashion in coming years. An aging population will also need more healthcare and Medicare costs will explode.

Fortunately, our interest rates are low and they have benefited from a “flight to safety”. If our interest rates suddenly reversed, our deficits would grow rapidly. Our balance sheet is not much better than Europe’s and with 10-year rates at 1.4%; we should be rolling our debt into longer maturities like mad (while investors are still willing to lend us money). Currently, the average duration in our country’s debt is less than four years. We are very vulnerable to any increase in yields.

Entitlement needed to be reformed decades ago. Now so many people are dependent on it that any cutback will result in riots. I don’t know how much longer this “Ponzi scheme” will continue, but we are in the late stages of this con. Spain and Italy are game changers.

Earnings have been decent and two thirds of S&P companies have exceeded profit forecasts. However, three quarters of the companies have messed top line estimates. This is rather discouraging given that the strongest companies released earnings early in the cycle. Q2 preannouncement warnings were much greater than Q1. Analysts lowered Standard & Poor’s 500 estimates .8% and I believe there is lots of room for disappointment as earnings season unfolds.

When corporations hit the bottom line but missed the top line, it is a sign of cost-cutting. It demonstrates that they are cautious and they won’t be adding to payrolls. We can expect the unemployment rate to creep higher.

Euro credit concerns, a slowdown in China, cautious earnings guidance, the November elections and the “fiscal cliff” will all weigh on the market. Tomorrow morning, flash PMI’s will be released. The expectations are fairly low, but this reminder of deteriorating economic conditions will spark another round of selling. Later in the week, Q2 GDP will be released. Analysts are scrambling to lower their forecasts and the consensus is somewhere around 1.7%.

We might see a couple of small snapback rallies this week, but they will all fade quickly. Look for opportunities to get short.

Last Friday I bought back all of my put credit spreads; I bought VIXY/VXX calls and I bought a few puts. My plan was to buy more puts this morning and I still intend to do that. The initial move this morning was overextended and the market has been able to rally off of its lows (11:30 am ET). I am buying more puts now and I believe the market will close on its lows.

I know that there are still strong earnings that will be released this week and I might have to “whether a few storms”. However, I believe a longer-term decline has started and I want to add to bearish positions every chance I get.

Get short.
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