Ride the Rally – Use Trailing Stops. Euro Interest Rates Are A Huge Warning Sign

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

In the last two weeks, the market has declined after getting positive news from Europe. Spanish banks received $125 billion from the EU and pro-bailout candidates won elections in Greece. Unfortunately, these “fixes” are temporary in nature. The market is forward-looking and it sees trouble ahead.

Many analysts believe that Spain will need three times more money to “shore up” its banks. The bailout news last week barely hit the wires and interest rates started to climb. The opposite reaction was expected. Yields have crossed over the 7% mark and this is considered “the point of no return” by most Asset Managers.

The “genie is out of the bottle” and Spain will have an impossible time raising capital. This week it will auction three and five year bonds. I believe the ECB will reluctantly support the auction. If they don’t, interest rates will spike.

Yields in Italy are also making new highs for the year. Structural deficits cannot be solved with austerity and bailouts. Massive entitlement reform is needed and member nations refuse to address the source of the problem.

Pro-bailout candidates won elections in Greece by a slim margin. They will be able to form a coalition and they will struggle to adhere to austerity promises. The country is divided and the situation is dire. Tax receipts are declining and deficits will grow. By October, Greece will be back at the trough.

The big economic news this week will be the flash PMI’s Thursday. Analysts are expecting weak results in Europe and bad news is already priced in. Activity in China is slipping, but traders will look past the number. The PBOC has lowered bank reserve requirements/interest rates and the government spending money on infrastructure. Both of these actions stimulate their economy.

The FOMC will release its statement tomorrow. The rhetoric will be dovish, but I am not expecting QE3. This could weigh on the market.

Last week I mentioned that the news from Europe should lead to a relief rally. That reaction has been muted and I believe the momentum will stall soon. Asset Managers are not aggressively bidding for stocks and we are close to overhead resistance.

Interest rates are at historic lows and stocks are attractively valued. This will attract bargain hunters, but no one is worried that they will miss the next big rally.

Yields in Italy and Spain are problematic. The issues will continue to fester and Eurocrats will disappear on vacation. Investors will get nervous and the market will decline. Earnings season could also bring warnings. This morning, FedEx missed its number and is considered an economic barometer.

I am long calls. I sold out of half of my position early yesterday and I locked in profits. The market started to recover and I held on to the other half. As long as stocks continue to grind higher, I will hang on. However, I am using trailing stops. The 100-day moving average is at SPY 136 and I believe it will provide resistance.

If interest rates in Spain and Italy continue to rise, I will stage orders to buy puts on a reversal. As the market rallies, I will ratchet up my orders. These yields are a huge warning sign and we could be close to a flashpoint.

We could see weakness Thursday. The market will struggle with the FOMC (no QE3); flash PMI’s, a soft initial claims number and dismal bond auctions in Spain.

Ride the rally, but use trailing stops. I plan to be out by the FOMC.
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