Market Support Is Holding. Start Selling Put Credit Spreads On the Next Dip. Scale In.

May 10, 2012

This week European credit concerns flared up and the market tested major support levels. Horizontal support at SPY $136 was breached and the SPY touched the 100-day moving average ($134.70) briefly. Asset Managers are passively bidding for stocks.

The price action during these two declines indicates that support should hold. Tuesday and Wednesday the market staged a deep intraday decline and in both cases, stocks recovered. Option implied volatilities (VIX) have reluctantly edged higher and that suggests that fear is relatively contained.

The news has not been great, but it is not devastating either. Let’s start with Europe since it is the source of all market woes.

France elected a socialist and he promises to cancel austerity plans. Hollande intends to tax and spend. His policies won’t have an immediate impact, but they will have long-term consequences. Entitlement needs to be reformed and it won’t happen as long as he is in control. This is the biggest source for budget deficits (not discretionary fiscal spending).

Interest rates in Spain have climbed to all-time highs. Their banks are grossly undercapitalized and the country is forming a “bad bank”. These plans will be outlined tomorrow. Spain announced it will take a 45% stake in its fourth-largest bank. It is trying to isolate the problem so that contagion can be avoided. This should calm market nerves.

Pro-bailout candidates in Greece are slipping in the polls. Communist candidates threaten to cancel austerity agreements if elected and IMF bailouts would be jeopardized. This would send Greece into immediate default. The elections over the next few weeks will be important. From my perspective, Greece is a never-ending problem. Its issues run so deep that European officials need to consider cutting them loose.

Europe’s economy is very soft and next week they will release Q1 GDP. Germany is a concern. It has been a cornerstone for EU economic stability and its activity is declining.

China posted its trade balance overnight and it was fair. Exports did not increase as much as expected. Tonight, they will release CPI/PPI. Inflation has fallen below 4% and that should pave the way for easing. The PBOC has hinted that it will lower bank reserve requirements. This would be good for commodity stocks. Their GDP rose 8.1% in Q1 and that is robust growth. In two weeks we will get the flash PMI.

Domestic economic releases have been soft. ISM services, ADP and the Unemployment Report all missed expectations. The silver lining is that initial claims dropped significantly last week and that was not reflected in the jobs number. This morning, initial claims increased by 1000. It appears that the warm weather employment distortion from two months ago has run its course.

The economic releases next week included Empire Manufacturing, initial claims and the Philly Fed. ISM manufacturing came in better than expected last week and these numbers should be decent.

Earnings season is winding down. Corporate profits were up 10% year-over-year and the guidance has been good. Last night, Cisco posted earnings a light forecast for Q2 sparked a big decline this morning. Stocks are attractively valued at a forward P/E of 13 and the market should be able to find support at this level.

The “sell in May and go away” adage has worked the last two years and investors don’t want to make the same mistake. This selling pressure will run its course during the next week and prices should stabilize.

European credit concerns are the wild card. Spain’s interest rates are dangerously high and if they break out, they will pass the point of no return. Default risk will be priced in and fear will take over. The IMF’s $1 trillion slush fund will be “eyed up”. Italy’s interest rates are relatively stable and Spain seems to be the real issue at this time.

I liked the intraday reversals off of major support this week and the decline had a slight capitulation feel to it. Stocks started off on a strong note today and they have given back some of the gains. On the next decline I would like to see buyers step up at a higher level. If they do, that will tell me that Asset Managers are putting money to work. I am ready to scale into out of the money put credit spreads. This is my core strategy right now.

From a day trading perspective, I will only buy dips once market support is established. I like to pick out my stocks early in the day and then I place buy stops above resistance levels. If the stock rallies above those price points, I get filled on the way up. I place my exit stop just below my entry point and I let momentum take care of the rest. I have been day trading recently to navigate this choppy market and to reduce overnight risk.

I believe the market will fall into a choppy trading range for the next few weeks and support at SPY $134 will hold. Be ready to sell put credit spreads on strong stocks.
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