Let This Bounce Run Its Course. Buy Puts When the Rally Stalls. Spain and Greece Are An Issue.

May 29, 2012
Author: Peter Stolcers, Founder of OneOption

May has not been a “market friendly” month. Stocks have fallen below major support levels on European credit concerns. Economic activity has been soft and that has also contributed to the decline. Last week, the SPY bounced before it testing the 200-day moving average. The volume was light and this was nothing more than a pre-holiday round of short covering. Over the weekend, pro-bailout candidates (New Democracy) in Greece regained a small lead in the polls. If Syriza (anti-bailout party) wins the election in three weeks, Greece will default. European officials are finally talking about an EU without Greece. The improvement in the polls sparked a round of buying, but other issues loom. Spain's banking system is dangerously close to collapse. The country plans to issue debt to the banks in exchange for equity. Spanish banks will pledge those bonds with the ECB (exchange for money). This "backdoor" approach will allow Spain to issue debt away from capital markets. Six months ago, the ECB said that it would not actively participate in sovereign debt auctions. It did not want to be the buyer of last resort. Apparently, that has changed. Now they are buying Spanish debt through the banking system. Interest rates in Spain have climbed to new highs. This is a huge "red flag" and you can see the breakout in the charts below. If Greece defaults, the market will tank. However, I believe European banks will be able to shoulder the hit. They have borrowed more than $1 trillion from the ECB and the IMF stands ready with $1 trillion in its coffers. That money would have to be infused instantly into Spain and Italy to prevent contagion. Here is the rub, Greece has not defaulted and the focus is already shifting to Spain. The market has already lined up the “dominos”. The developments in Europe tell me that any rally will be short-lived. Economic conditions are deteriorating and the flash PMIs last week were dismal. This Thursday, the official PMI's will be released for Europe, China and the US. The bad news is already "baked in", but the release will be a reminder that conditions are deteriorating. China will initiate a huge fiscal spending plan in coming months. They will expand their infrastructure and they will offer a rural auto subsidy. Cement and steel producers moved higher in trading yesterday. Their economic activity has been growing, but it has not lived up to expectations. Bank loans in May are down and electricity consumption has declined relative to Q1. Strength in China will not offset flat conditions in the US and deteriorating conditions in Europe. Growth has stalled in the US. ISM services, durable goods orders, Empire Manufacturing and the Philly Fed all came in "light". Initial jobless claims are hovering around 370,000 and this week's employment numbers will barely tread water. Traders will pay particular attention to Thursday's ADP report. In the last six months it has produced more of a reaction than the Unemployment Report. It has been "tracking" well and it is an accurate representation of employment conditions in the private sector. ADP processes payrolls for small and medium-sized businesses so they have their finger on the pulse. The consensus estimate is for 160,000 new jobs in May. That would be a 40,000 increase over April's number and I believe it is too optimistic. Initial jobless claims have not declined in recent weeks and I believe it will come in around 120,000. The consensus estimate for Friday's Unemployment Report is 150,000. I believe that number is also high. This morning, consumer confidence fell to its lowest level since January. The market was able to shrug off this number, but it is another sign of weakness. Last week, Tiffany provided dismal guidance and this demonstrates that even the luxury end of retail (which has been resilient) is feeling the pinch. Last week, DELL and NTAP provided disappointing guidance and the market declined on the news. This confirms CSCO's statements and tech stocks will be sluggish. Asset Managers will nibble on pullbacks, but they will not aggressively bid for stocks. There is too much uncertainty and they will wait for the election results in Greece. They will also watch interest rates in Spain. If global economic conditions were stronger and earnings guidance was positive, they might be inclined to look past European credit concerns. That is not the case. I believe this market rally will stall and I am adding to my put positions. I bought a handful of puts last week and I suggested keeping your positions very small. Time decay over the weekend was an issue and I suspected that we might see a little improvement in the Greek polls. Today, I will purchase more puts and I will scale in throughout the day. I plan to have 20% of my normal position on by the close. This week I will build to a third of my normal position. I won't go beyond that level unless I see Spanish rates continue to climb. This yield level is considered the “point of no return” by most analysts. Once this bounce stalls, I believe the SPY will test the 200-day moving average. If the Greek elections are still a 50/50 proposition next week, I believe Asset Managers will pull bids and we will breach the 200-day MA. Try to keep your powder dry as long as possible. With every move higher, option implied volatilities will decline and you will have a better entry point. The market has been able to grind higher from the open and that momentum is likely to continue into the close. Late day selling (unlikely today) would be a bearish sign and I will get more aggressive in my put buying if I see that. The SPY will hit resistance around $135 and that would be an excellent entry point for shorts if we can get back to that level. Be patient. . . image

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