Good Earnings and Momentum Will Push Stocks Higher. Take Profits Along the Way!

July 19, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Yesterday, stocks rallied on good earnings. Traders also anticipated good results from IBM, eBay and QUALCOMM after the close. Resistance at SPY $136 was breached and shorts covered.

The overnight earnings news has been very positive. Stocks rallied on the open and they pulled back briefly. This second wave of buying looks like it will last the remainder of the day. Google and Microsoft will post earnings after the close.

In general, profits have been good and guidance has been cautious. That scenario was already priced in and stocks have been able to push higher. European interest rates have been stable and economic releases have been light. Traders have been able to focus on earnings. Keep in mind that the strongest companies announced early in the earnings cycle. We still have one more week of positive price action.

Spain held an auction this morning and it did not go particularly well. Yields are at 7% and most analysts consider that the point of no return. Spain will get $100 billion in aid and it will use most of that for bank loans. I’m hearing that Spanish banks are tapped out and they don’t have any capital to participate in future bond auctions. In fact, rumor has it that Italian banks were “encouraged” to buy up half of its sovereign auction last week. This is a sign of weak global demand and it is a huge warning sign.

This morning, initial claims climbed by 20,000. It fell by almost the same amount last week and I believe this is simply a holiday adjustment. The Philly Fed was -12.9 and that was largely in line. The next big economic news will come on Tuesday when flash PMIs are released. I believe the news will be a little “heavy”, but the market will be able to shoulder it.

A week from tomorrow, Q2 GDP will be released. I will be out of long positions by then. Analysts have been reducing estimates and the consensus is somewhere around 1.7%. This week the Fed Chairman said that economic conditions are deteriorating. I believe the probability QE3 has increased and we will probably hear “dovish” rhetoric during the FOMC statement (8/1).

Worst case scenarios were priced in and stocks are staging a nice little “relief rally”. The market is trading at the 20-day highs and option expiration should have a positive influence. Once the momentum stalls, be ready to buy puts.

There have been more pre-announcement warnings in Q2 than there were in Q1. Analysts have only reduced earnings estimates on the S&P 500 by .8%. That leads me to believe that there is plenty of room for disappointment as earnings season continues.

A weak round of economic releases and a slight move higher in European bond yields will prompt profit-taking. The market is inching closer to major resistance at SPY $142. I don’t believe it will get anywhere close before rolling over. At best, we will see SPY $140.

I am short out of the money put credit spreads and I focused on companies that generate most of their revenues in North America. That strategy has worked well and I’m ready to reel in those positions at the first sign of trouble. I will purchase puts if the SPY trades below $136. If the market moves higher, I will ratchet my entry point higher.

Cautious earnings guidance, deteriorating economic conditions, rising yields in Spain and Italy, November elections and the “fiscal cliff” will weigh on the market in August and September. Option implied volatilities are very low and that is a sign of complacency. The table is set for a sell-off.

Ride this rally higher for another week, but take profits along the way. When the tide turns, it will reverse quickly.
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