China Lowers Interest Rates. Good News Is Priced In. Look for An Opportunity To Get Short

June 7, 2012

The worries of the world have quickly vaporized. Last week, the market broke below the 200-day moving average and this week they have staged a 5% rebound. Now we need to figure out which of the two moves is legitimate.

Greek elections will be held in two weeks. The market has priced in a victory for the New Democracy. They will honor prior austerity agreements if elected (only a 2% margin ov victory), but major problems still exist. Tax revenues in Greece are plummeting and they won’t cover expenses. Another bailout request is right around the corner.

Spain’s banking system is in dire straits. The country proposed a “bad bank” plan and investors were disappointed by it. Spain wants the ECB/IMF to lend money directly to the banks, but the EU (Germany) objects. Eurocrats want Spain to secure a bailout and then to loan the money to their banks. This would mean that Spain would have to agree to fiscal spending restrictions and they don’t want to lose that control. Unlike Portugal, Greece and Ireland, Spain has not been running massive deficits and they might have a little bargaining power. The negotiations will take time (perhaps weeks) and the market will grow impatient.

This morning, Spain held a successful bond auction. That is pushing European stock markets higher. I believe the auction went well because the ECB supported it. Credit conditions are tenuous and the ECB could not risk another spike in yields. Rates are already dangerously high (6.5%).

The ECB released a statement yesterday. They will continue to provide liquidity, but LTRO3 is not currently being considered. Many traders were hoping for another cash infusion. Even if the ECB launched it, European banks might not have eligible assets to pledge.

Today, the Fed Chairman will testify before Congress. He will discuss the state of the economy. Given the recent decline in job growth, many traders believe that “helicopter Ben” will revive QE3 hopes. Even if he does, another round of easing won’t stimulate economic growth. The Fed has maintained “loose” monetary policy the last four years and our economy is barely treading water. I believe Ben Bernanke will not mention QE3 (he won’t fire his last bullet until conditions are dire) and he will discuss the likelihood of economic contraction. His remarks should weigh on the market.

ISM services came in slightly better than expected this week, but the increase was negligible. Initial jobless claims dropped to 377,000 and the number was market neutral. Job growth is contracting.

Corporations will not invest during times of uncertainty. Europe poses a big threat and conditions are deteriorating. Furthermore, November is drawing closer and polls suggest that the presidential race is a dead heat. Mandatory fiscal spending cuts will kick in January 1st and we might have to go through another debt ceiling debate. This dark cloud will approach in another month.

We’ve heard from Cisco, Dell, Hewlett-Packard and Network Appliance. The guidance was weak and corporations are holding off on capital expenditures.

Stocks are attractively valued and balance sheets are strong. With ten-year yields at historic lows, Asset Managers will bargain-hunt when stocks decline. However, with all of the uncertainty, the bid will be passive and they will not chase.

Overnight, China lowered interest rates by .25%. This move was not expected and it is bullish for the market today. Global economies are depending on sustained growth in China. Economic activity has been slowing recently and this should temporarily revive confidence. Out of all of the news today, this was the most bullish event.

You can probably tell from the “slant” of my commentary that I am not buying into this rally. Best case scenarios are priced into the market and there are plenty of “land mines” ahead. Greece will need more money, Spain will resist bailouts and push for direct aid to banks, economic conditions will continue to contract as corporations postpone capital expenditures and earnings warnings are likely.

The market should hit technical resistance at SPY 134. I believe this short covering rally will stall in the next few days (perhaps today). We have rallied far enough for me to consider put purchases. If the market can’t make a new daily high this afternoon, I will buy a few July puts. If I see selling into the close, I will add to the position and build to 20% of my normal size. I don’t want to buy June options because of time decay. I also know that I am early on this move and stocks might not rollover for a week or two. That is why I will patiently scale in.

If the market continues to grind higher into the close, I will not purchase any puts. That would signify that the market still has some upside. I am certain that Asset Managers will reduce risk at the 100-day MA (SPY 136) and we will see heavy resistance at that level.

Monetary easing is “market friendly”, but it is being used to fend off economic contraction. Also keep in mind that prior actions have been ineffective.

Look for an opportunity to get short and scale in knowing that we are early and we will take a little heat.
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