No QE3 – Market Wants It. A Slowdown In China Is Priced In. Any Surprise Favors Upside.

July 12, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Yesterday, the market continued to leak oil. The FOMC is not considering QE3 and traders wanted the tone to soften. This morning, the S&P 500 is trading 14 points lower on the open.

Central banks around the world are easing. Last week, China, the ECB and the BOE reduced interest rates. Last night, Brazil and Korea (surprise) reduced interest rates and Japan increased its asset purchase program. This news should be very positive for the market and it is not smart to fight easy money.

Interest rates have been pushed down to historic lows and Asset Managers will rotate into equities when they reach bargain levels. Stock valuations are attractive and corporate balance sheets are strong. Earnings season typically generates a nice rally and traders temporarily ignore credit concerns.

The fact that the market has been able to drift lower is somewhat concerning. Investors realize that “easy money” won’t solve long-term structural deficits. Central banks are running out of bullets and now that interest rates are at zero, they can’t move any lower. Massive monetary stimulus in the last few years has not generated an economic recovery.

China has been the cornerstone for global economic growth. Its activity is contracting and traders are focused on major releases tonight (industrial production, new loans, retail sales and GDP). The consensus estimate is for GDP to decline from 8.1% in Q1 to 7.8% in Q2. I believe the market has factored in 7.6% growth. If the number is materially below 7.6%, we could see a round of selling.

Two days ago, Cummins said that sales for 2012 will be flat. It had projected 10% growth and it cited weakness in China as the primary reason for the miss. This warning sparked a selloff and cyclical stocks were nailed Wednesday.

Today, the trade balance came in better than expected and initial claims dropped 20,000 (350,000). This round of good news did not attract buyers and the S&P futures shrugged off the releases. The economic releases next week are fairly benign (Empire Manufacturing, retail sales, CPI, the Beige Book, and initial claims).

Alcoa posted earnings earlier in the week. They beat estimates and stood by their 7% revenue growth forecast for 2012. The stock was at the low end of its range and it still declined after a decent report. Tomorrow, J.P. Morgan and Wells Fargo will post results. These are two of the strongest banks and I’m expecting good numbers. This will set the tone for the financial sector.

Earnings season will truly kick off next week. Tech stocks have been beaten down and Intel, eBay, Microsoft and IBM should attract buyers. I am not looking for a major rally, just an earnings bounce.

I feel that shorts are getting a little too aggressive. Any surprise from China favors the upside. Worst-case scenarios are priced in and we could see a short squeeze.

The next big move is down, but I still believe it is too early.

In the event that I’m wrong, I will only purchase puts if the SPY breaks below $130. That is a major support level and a breach would be very bearish.

Stocks will probe for support today. If the selloff gets ugly, I will sell out of the money put credit spreads. I have been selling a few spreads this week, but my size has been small. I will ramp up if we hit an “air pocket” today. Companies that primarily generate revenues in North America are my target. They include retail, restaurant, homebuilding, healthcare and tech.

Yields in Europe were steady today and central bank easing should pacify credit concerns for a few weeks. If we can get past China’s economic releases tonight, traders will focus on earnings. I’m just trying to ride out this last wave of buying before I start taking bearish positions.

If you are short, I suggest covering some of your positions today. You will have an opportunity to get back in.
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