Appetite For Risk Is Damaged. Earnings Rally Will Be Tenuous. Support At SPY 139 Is Critical

April 5, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Yesterday, stocks tested the downside after Spain’s dismal bond auction. Peripheral interest rates moved higher and they are up 10 basis points in Italy and Spain today. In both cases, yields are at two-month highs. There really hasn’t been any news to justify the move.

The market has a complete lack of confidence in the EU. They boosted their firewall by €200 billion last week and Spain released an aggressive 2012 budget. The market seemed to like the news.

Unfortunately, the LTROs were a temporary solution. The ECB allowed cash-strapped European banks to pledge toxic sovereign bonds in exchange for cash. In theory, banks would use this money to beef up balance sheets and to purchase more sovereign debt. This would keep a lid on interest rates. The maneuver worked, but the underlying problems still remain.

European nations are running massive deficits and entitlement programs continue to pull them deeper into the abyss. This problem has not been addressed and austerity measures barely scratch the surface. Retirement benefits need to be reformed and an aging population will accelerate deficit spending in future years.

European banks have been lending money to sovereigns and their risk exposure is incredibly high. These bonds have declined in value and banks have not taken write-downs. If Basel III were passed 75% of European banks would fail. Their appetite for additional sovereign debt is low and many analysts feel that the rest of the world will have to pick up the slack.

Global financial institutions and pension funds are staying away from European debt. The entire EU structure is fragile and the union is fragmented. A unanimous vote is required to get anything passed and there is no sense of urgency.

Four months ago, we were on the brink of a financial crisis. The ECB dragged its feet until the 12th hour and then it launched the LTRO. Eurocrats promised to forge fiscal reforms by March and to add them to the treaty. Interest rates dropped and the pressure was off. In the last few months they have not made any progress.

The market has very little confidence in Europe. In a few months, Eurocrats will postpone major decisions so that they can go on vacation. We’ve seen a steep decline the last two years and we are setting up for the same cycle.

This roller coaster is almost impossible to predict. One minute everything is fine and the next minute fear takes over. Spain and Italy have held auctions almost every week for the last few months. All it took was one dismal auction to spark a European selloff.

The other news is good. China’s market reopened for the first time this week and stocks rallied 1.7%. A better-than-expected PMI attracted buyers. There is also a good chance that bank reserve requirements will be lowered in coming weeks.

In the US, ISM manufacturing was better-than-expected and ISM services with slightly lower than expected. In both cases, the numbers were good. ADP employment came in at 209,000. That was slightly less than the 217,000 that was projected, but the number was still solid. This morning, initial claims dropped by 5,000 and that bodes well for tomorrow’s jobs report.

The market will be closed tomorrow and traders will square up today. They don’t want to have a lot of risk exposure over an extended weekend. Last week, I thought the greatest risk would be to get caught short. Now I’m not so sure. European markets are weak and traders might not want to be long.

In the last few months, ADP has exceeded expectations and the market has rallied. Friday’s Unemployment Report has been a non-event because the news is already priced in. Analysts are projecting 205,000 new jobs in March. That number should be fairly easy to hit.

Earnings season will start next Tuesday. Alcoa has pulled back and the expectations are low. I believe the actual number will be soft, but the guidance could spark a rally. China’s economy is on the mend. Cyclical stocks have not participated in the recent move and I believe there is upside.
A few tech stocks (ADTN, SNDK, TXN) have warned and that seems to be concentrated in the handset industry. Otherwise, there have not been many warnings.

If not for Europe, I would consider yesterday’s move the perfect shakeout. Asset Managers pull their bids and they buy like crazy into earnings season. Now, I feel that their appetite for risk might be damaged. Stocks will rally on earnings news, but the move will lack punch.

Prices stabilized yesterday, but we did not get the late round of buying I was looking for. I am glad that we are testing the downside first today. If we see a floor early and a rally, we could get back on track.

If the SPY closes below 139, I am taking my call positions down to 50% of my normal exposure (from 65%) and I am buying VXX as a hedge.

I don’t like the European wildcard over a long weekend. If we get a strong jobs report, it won’t matter if European stocks continue to tank. Their markets have found support and I would like to see them rally into the close in 2 hours. That would push the SPY back above $140.

I still feel the market has one more good push higher. I will be taking profits even earlier (SPY 144 vs. 146) now that Euro credit concerns have returned. When this rally stalls in a couple of weeks, there will be a nice shorting opportunity.

If Europe finishes off its lows, our market will rebound to SPY 140.50.

The market is closed tomorrow, but I will post a few comments on the Unemployment Report.
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