Housing Starts and Initial Claims Improve. The News Won’t Break Us Out of This Range

February 16, 2012

Yesterday, the market gaped higher and it spent the rest of the day giving back those gains. By the end of the day we slipped into negative territory. Stocks are bumping up against major resistance and there is selling pressure at the SPY 137 level.

In the grand scheme of things, this mini selloff doesn’t mean much. The news calendar is very light and traders are searching for anything they can latch onto.

European credit concerns have subsided, but conditions can deteriorate at any time. The ECB will provide another massive liquidity injection in two weeks and that should support upcoming sovereign bond auctions for maturities under 5 years.

European banks are running out of collateral to pledge and this maneuver will run out of steam in a few months. Once European banks secure the loans from the ECB, they theoretically will purchase sovereign bonds. They are already sitting on a mountain of PIIGS debt and I doubt they will take a second bite from that rotten apple. European interest rates will start to inch higher in March.

France will hold elections in April and politicians will fight to maintain stable conditions. Greece will also hold elections in April. The troika wants guarantees from officials that austerity promises won’t be broken by the new regime. Trust is the key to any union and it is running low in Europe.

China said this week that it will support Europe in some fashion. It has not given any details and this is probably just “lip service”. A few months ago they stated publicly that Europe has enough money to solve its own problem. Some analysts believe that China only has $500 billion in its coffers. The other $2.5 trillion in reserves is being used to service internal needs.

Earnings season is winding down and retailers will post results next week. Extended store hours and heavy discounting will bite into profit margins. The news will be mixed, but it will have a slightly negative bias.

Profit growth across the entire S&P 500 has been 6.6%. This is the worst showing in over two years. If you strip out Apple’s earnings, profit growth for the S&P 500 slips to 2.6%. That is very telling. The growth is very concentrated and that is not a healthy sign.

The economic news has been positive. Conditions in China are stable and the decline in growth has stalled. Officials predict that inflation will drop to 4% (the lowest level in 17 months) and that could pave the way for easing. I still believe that China is on the brink of a “housing bubble” and that could be a factor this summer.

Europe posted its GDP and industrial production this week. France and Germany are keeping their heads above water, but the rest of Europe is weak.

In the US, economic releases have been positive. A slight decline in industrial production was negated by a better-than-expected Empire Manufacturing number. This morning, the PPI was benign, housing starts were better-than-expected and initial claims dropped to 361,000. The jobs number came as a surprise and the market rallied on the number. Employment has been picking up the last few months and that could lead to a sustained economic recovery.

For now, credit concerns are off the table and earnings season is almost over. That means the focus will shift to economic releases. Flash PMIs from Europe and Asia will be released Wednesday. That is the only major news event next week.

The market is due for a pullback, but Asset Managers are eager to buy on dips. By the same token, the market is bumping up against major resistance and every time we try to break out, profit taking sets in. These two opposing forces are keeping us in a tight trading range and we need a major news event to break us out.

I have been buying calls on stocks that consistently rise to the top of the Live Update table in the DAILY OPTION REPORT. In particular, I like breakouts after a period of consolidation. I am hedging these positions with VIX calls. If the market does decline, option implied volatilities will jump. My losses on the calls will be off-set by my gains in the hedge. If the market rallies, the VIX won’t decline much from this level and my losses will be contained. The profits on my long positions will more than offset these losses.

I consider this “no man’s land”. The market could break either way so I’m keeping my positions small. I believe that any pullback will be a buying opportunity and I will get more aggressive once support is established.

By the end of April, problems in Europe and China will start to fester and the market will be vulnerable. There is plenty of time before that happens.

Yesterday’s selloff continued overnight. The S&P 500 rebounded after the initial claims number this morning. I believe we will see an attempt at a rally and prices will soften towards the end of the day. Look for choppy trading within this range for the next week.
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