Short Covering and A Light Round of Bargain Hunting. The Market Will Test Support Next Week.

May 22, 2012

After breaching major support levels last week, the market rebounded yesterday. The buying started early and short covering pushed stocks higher throughout the day. The news did not justify the move and I believe this is just a technical bounce.

First off, the market did not deserve to trade down to Friday’s lows. Panic selling was accentuated by option expiration. The SPY was just above major support (the 200-day moving average) and a small dose of good news sparked a relief rally.

Pro-bailout candidates in Greece are faring better in the polls. Politicians have still not formed a coalition and leftists could take control in a few weeks. That would send Greece into immediate default.

European officials are preparing for a Greek departure. Until recently, they have not entertained this idea. I believe contagion will be prevented, but the market will plunge on the news. Once the dust settles, stocks will rebound. After a few months, the focus will shift to Spain and Italy.

Eurocrats are considering a bank depository similar to FDIC. They are long on ideas and short on action. You might recall that they were going to forge new fiscal policies for the entire EU when the @#$% was hitting the fan back in November. They had a March deadline and these policies have not been discussed in months.

Spain’s banking situation is dire. A month ago analysts believed that they might need €30 billion to shore up the problem. Each week that number grows and now it is up to €60 billion. The write-downs could exceed €250 billion.

As the year progresses, the US debt ceiling will become a concern. Politicians structured this so that it would not be an issue before the November elections. Unfortunately, we will run out of money before then. The last round of negotiations resulted in a US credit downgrade by S&P. The stalemate also yielded mandatory fiscal spending cuts that will begin on January 1st.

These are long-term issues that will cast a dark cloud over the market this summer. Corporations are cautious and job growth is stagnant. China’s economic activity is sluggish and it won’t offset deteriorating conditions in Europe.

Thursday morning, flash PMIs will be released for China, Europe and the US (first time ever). The market has rebounded 3% in the last two days and I believe the news will be benign. Europe will be slightly better than expected (worst case already priced in) and China will be slightly worse than expected (good growth, but below estimates).

Initial claims could decline slightly. Unemployment applications drop ahead of major holidays because people postpone filing. This could be a small positive for the market, but the improvement will reverse itself next week.

The market was oversold last week and this bounce will stall at SPY $134.70. The 100-day moving average was support and now it represents resistance.

Short covering and a small round of bargain hunting are the catalysts. This light volume rally will stall and we will fall into a tight trading range towards the end of the week.

The last two years, the market resumed the decline after Memorial Day. If Greek politicians don’t form a coalition, the market will decline next week. The higher we move from this level, the more inclined I am to buy puts. Option implied volatilities are getting crushed (I mentioned that this would happen last Friday) and premiums are getting cheap enough to consider buying puts again.

I am flat. On a short-term basis, I am day trading this rally. I want to keep my overnight risk exposure very small. Without anything standing in its way, stocks could drift higher on light volume today. Use the Live Update table as your guide and focus on stocks that are at the top.

Support level will be tested a second time. The news out of Greece and China will determine if that support holds or fails. Keep your positions small this week and wait for clarity.
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