China’s Rate Cut Could Be A Sign Of Trouble. Fade the Bounce and Buy Puts On Weakness

June 8, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Last week, stocks broke below major support and this week they rebounded. As you know from my comments, I believe this 5% rally is nothing more than a technical bounce. Economic conditions are deteriorating and the credit crisis in Europe is escalating.

The market believes that the New Democracy will win Greek elections on June 17th. That might be true, but tax receipts are plunging and revenues will not cover expenses. Greece will soon be asking for more bailout money and the problem will continue to fester.

Spanish banks are in dire need of capital. The EU (Germany) wants Spain to apply for aid so that it can recapitalize its banks. This course of action would force Spain to give up control of its fiscal spending and it doesn’t want to do that. It wants the ECB/IMF bailout its banks. Analysts estimate that $50 billion will be needed and this negotiation will continue for weeks. The market will grow impatient and Eurocrats will go on vacation.

Yesterday, Spain successfully auctioned bonds. I told you that the ECB probably supported the offering to avoid another spike in yields. Conditions are tenuous and they need to suppress fear. Today, Spanish yields are up 23 basis points and they will continue to climb until a banking solution is reached.

Economic activity in Europe has been contracting. Germany has been the cornerstone and even its PMI has been falling.

China lowered interest rates in a surprise move yesterday. The .25% reduction was the first in two years. In my comments yesterday, I warned that monetary easing is used to fight economic contraction and it is not always a good sign. This weekend, China will release industrial production, retail sales and inflation numbers. I believe they will be weak and China wanted to front run dismal numbers with a rate cut.

This morning, the US released its trade balance. Imports and exports declined. Exports to Europe fell 11% in exports to China fell 14%. Economic contraction is spreading.

Corporations and Asset Managers don’t want to invest during times of uncertainty. European credit concerns, Greek elections, the debt ceiling, 2013 fiscal spending cuts, the Supreme Court decision on national healthcare and the November elections are all weighing on the market. We heard from Dell, Hewlett-Packard, Cisco and Network Appliance that corporations are holding off on IT purchases.

I believe we will get a round of earnings warnings ahead of Q2. Next Monday we will get a mid-quarter update from Texas Instruments. That would not normally be a huge market driver, but it could be given the backdrop.

There are a number of economic releases next week (retail sales, PPI, business inventories, initial claims, CPI, Empire Manufacturing, industrial production and consumer sentiment). I believe inflation will be benign and manufacturing will decline. Initial jobless claims could also creep higher. I would assign a negative weighting to the news.

The ECB said that they will remain accommodative, but LTRO3 was not mentioned. This was a small disappointment for the market. Furthermore, Chairman Bernanke did not mention QE3 during his economic speech yesterday. He said that Europe and future US fiscal spending cuts have increased the risk of an economic decline. He will not fire his final bullet until conditions are dire.

I told you yesterday that I would buy puts if the rally did not hold. I am long 20% of my normal position. I will add if I see a new low later this morning. If China posts solid numbers over the weekend, the market might rally, but overhead resistance at SPY 134 is close by. On the other hand, if China (our last hope) posts a weak numbers, the market will decline and it could test last week’s lows. The rate cut yesterday might be preempting dismal data.

If by chance the market rallies back to the 100-day moving average, I will wait for the momentum to stall and I will aggressively add to put positions. Asset Managers will be looking for an opportunity to reduce risk and they will sell stocks at that level.

I suggest owning some puts and looking for an opportunity to add. If the market starts to drift lower, buy more.

Through Sunday, I am offering the Level 3 Option Report at 25% off the normal subscription price. The rate on the website already reflects the discount and the service was up $16,600 in May. I hope to have you aboard.
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