If ECB Supports Spanish Auction Next Week – Stocks Will Rebound On Earnings and Economy

April 13, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Yesterday, the market started off on a positive note and it added to gains throughout the day. Buyers ignored a mediocre Italian bond auction and weaker than expected initial jobless claims. By the end of the day, the SPY was back above the critical $138 level.

Some of the rally was tied to bullish expectations in China. Last night they released GDP and most analysts were looking for 8.4% (there were whispers as high as 9%). The actual number was 8.1% and that was a mild disappointment. Industrial production and retail sales came in better than expected. A week ago PMI was better than expected and this week the trade balance was decent.

Even at 8.1%, China’s economy is growing at a steady pace. Commodity stocks and cyclicals should fare well and they rebounded yesterday. Some analysts believe that the PBOC will lower bank reserve requirements in the next week or two and that should support their market. Stocks in Asia traded higher overnight.

Credit concerns in Europe are flaring up. Next Tuesday and Thursday Spain will be auctioning bills and bonds. The auction last week went poorly and it sparked a major market decline. The risk profile has changed in the last week and Asset Managers will not aggressively bid for stocks until they see interest rates in Europe declined.

The ECB could purchase sovereign debt or they could launch LTRO3. In either case, the actions will only have a temporary effect. The ECB has already stated that it does not want to be “the buyer of last resort”. They would rather lend money to European banks and have them buy sovereign debt. Unfortunately, Euro banks are up to their eyeballs in sovereign debt and they don’t want to purchase anymore.

Structural deficit problems have not been addressed. All of the austerity measures in the world won’t compensate for growing entitlement liabilities. Deficits will continue to grow and on a long-term basis interest rates will continue to climb. This one piece of the puzzle is almost impossible to handicap. Conditions can look great one-day and horrible the next.

Earnings season has kicked off and Google posted solid results yesterday. It will also split the stock. Even after this news, shares are down $20. Wells Fargo and J.P. Morgan posted results this morning. Revenues were up slightly, profits were down slightly and the results exceeded expectations. However, both stocks are down on the news and financial stocks might be poised for a decline after rallying 24% in the first quarter. Many major banks will post results next week.

In addition to an onslaught of earnings releases next week, the economic calendar is also pretty full. The releases include retail sales, Empire Manufacturing, housing starts, initial claims, the Philly Fed, and LEI. Initial claims could be the biggest news release. Traders will want to see if applications are on the rise after a weak number yesterday and after a dismal jobs report last week.

Market volatility is on the rise. Three months ago, stocks were in a nice steady climb and declines were a one-day event. In the last few weeks, the action has been “toppy” as multiyear resistance is tested. Good news is priced in and the leadership has been narrow. Apple alone accounts for 12% of the S&P 500 rally this year. Financials have also been a major contributor and they look tired. If the market is going to rally, it needs help from cyclical stocks.

I mentioned yesterday that I am only day trading at this time. I don’t like the overnight volatility and we are waffling back-and-forth around a major technical level (SPY138). We are back below that support level and the second breakdown is more meaningful. Yesterday’s gains have almost evaporated.

Here is how I see things playing out over the next few weeks. The major concern right now is European interest rates. Next week, the ECB will support Spain’s bond auctions and yields will stabilize. That will calm nerves and the focus will return to solid earnings. There have not been many earnings warnings and the results should be good. The economic releases should also be positive and stocks will try to rally. The rebound will be tenuous and shorts will be forced to cover.

Once this final push higher runs its course, there will be an excellent shorting opportunity towards the end of April. The warning signs are apparent. Europe is all about short-term solutions and traders know it. The demand for sovereign debt is weak and interest rates will continue to trend higher. Eurocrats will go on vacation and the market selloff as it has the last two summers.

Today I am looking to sell some put credit spreads on cyclical stocks and some commodity stocks. The news out of China has been good and these stocks are at major support levels. Options premiums are expanding and there are some nice credits. These stocks have lagged the market rally and I believe the downside is relatively contained.

The market should find support at SPY 135 ahead of Spain’s auctions next week. Good earnings and strong balance sheets will be tough to ignore and any improvement in Euro rates will spark buying.

I did not short the market this morning, but I might day trade a rebound today. If stocks establish an early low today and they don’t retest that low later, look for an afternoon rally (we will still finish down for the day if this plays out). If the market makes a new afternoon low, get out of the way.

SPY 138 is still a very critical level and as long as the market is below it, be cautious.

Keep your size small. Sell out of the money premium to distance yourself from the action and day trade intraday moves.
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