Horrible Spanish Bill Auction Priced In. Look For A Small Relief Rally. Sell OTM Put Spreads

April 16, 2012

The market rebounded on the open this morning after a nasty decline on Friday. Retail sales rose .8% and that was better than expected. Homebuilder confidence slipped and Empire Manufacturing fell to its lowest level in five months. The rally quickly faded and the market is in negative territory.

The biggest factor is European credit concerns. Spain had a horrible auction a month ago and yields have climbed above 6%. This is a critical level. Spain will auction bills tomorrow and bonds on Thursday. Traders are worried that the demand will be weak.

European banks are up to their eyeballs in sovereign debt. They don’t want to buy anymore and the demand will fade. Structural entitlement problems will drag “Club Med” countries further into debt. Until this is addressed, the debt will be toxic.

The IMF has not been successful in raising funds. They will meet this week and they are trying to raise $400 billion. Member nations do not want to add funds until they see Europe play a greater role.

Some analysts predict that yields will have to cross 6.5% before the ECB starts supporting the auctions (SMP). Others believe that rates need to cross 7% before LTRO3 is considered. The bill auction tomorrow should go better than expected. Traders are prepared for a disaster and the short and of the yield curve has typically seen decent demand.

If Spain’s auction is not disastrous, the market will stage a relief rally. Earnings have been fairly strong and the releases will crank up this week. We have not had many warnings and companies should be able to hit their numbers.

Financial stocks could see a bit of weakness. Revenues and profits have been soft and the price action after the release (JPM and WFC) has been negative. After a 24% rally this year, the financial sector could be vulnerable to profit taking. Moody’s will also be downgrading a number of banks and that could weigh on the sector as well.

Cyclical stocks and oil producers should perform well. The current numbers will “meet” and the guidance will be strong. China’s GDP came in at 8.1% last week. Industrial production and retail sales were better than expected. The trade balance and PMI are also better than expected two weeks ago. A recovery in China would get these stocks off the deck.

Oil has been above $100 per barrel the entire quarter and producers will have excellent profits. Integrated oil companies should also do well because refining margins expanded during the quarter.

All eyes will be on earnings this week. Intel, IBM and Seagate release after the close Tuesday. These companies will set the tone for the tech sector. Overall, the news should be good. On an interesting side note, Apple has been down 4 days in a row. It accounts for 12% of the S&P 500 rally this year. This one stock is important to the overall market. Keep a close eye on it. If the selling accelerates it would be negative for the overall market.

Most of this week’s economic news will come on Thursday (initial claims, housing starts, the Philly Fed and LEI). I feel the most important number will be initial claims. Applications spiked last week and after a dismal Unemployment Report, traders will be watching the jobs recovery very closely. A second consecutive bad number this week would weigh on the market.

The market is below critical support at SPY 138. I don’t have a great deal of confidence in my market forecast because the SPY is waffling back-and-forth around this critical level. My gut tells me that Spain’s bill auction will go better than expected tomorrow and the market will rally into major earnings after the bell (INTC, IBM, STX).

I still like cyclical stocks. They have not participated in the rally and I feel the downside is relatively contained. Conditions in China are improving and that will strengthen the bid.

I am selling out of the money put credit spreads below major support. I will also day trade stocks. Until I have a clear sense of direction, I want to distance myself from the action and keep my overnight risk exposure to a minimum. I believe we will see a low today and it will set up a buying opportunity.

That reprieve might not last more than 2 days. Spain’s bond auction Thursday and initial claims could be problematic and the market could pull back on that news.

I would like to see the market push higher for a couple of weeks. That would spark short covering and option implied volatilities would decline. If this transpires, it will set up a very nice put buying opportunity later in the month. The storm clouds are brewing and the table is set for a nasty pullback in May.
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