Central Banks to the Rescue. Remember, These Are Emergency Measures

November 30, 2011
Author: Peter Stolcers, Founder of OneOption

Yesterday stocks were able to hold gains after a 40 point S&P 500 rally on Monday. Asset Managers are looking for any excuse to buy stocks in this morning they got one. Just before the open, central banks announced a coordinated effort to supply liquidity to European banks. The situation was getting so dire that without intervention, we were on the brink of a financial crisis. Money market funds reported 9% less risk exposure to Europe in the course of a month and the ECB had the largest refi demand since June 2009. Liquidity is drying up quickly and European banks were asking the ECB to lighten the parameters for "acceptable collateral". On the surface, this news seems fantastic. The S&P 500 rallied 40 points and stocks were off to the races. Stock valuations are attractive and Asset Managers are praying for a year-end rally. If you lift up the hood, you realize that we were on the brink of a financial crisis and emergency measures were taken. This liquidity will prevent a financial crisis in 2011, but it won't rid banks and their toxic assets. Moody's said that it could downgrade 87 banks across 57 countries yesterday. European bank Dexia said that it would need additional bailout money. Belgium said that it did not have the funds to help it. This is one small example of what's to come. Governments are strapped for cash and they don't have the money for massive bank bailouts. The sovereign debt crisis is very real and interest rates across Europe have spiked. Bank liquidity is a symptom, but structural deficits are the real problem. Italy and Spain are on the ropes and a bailout could run well over $2 trillion. Since Europe announced its "grand bargain", not one dime has been raised by the EFSF or European banks. Much like the "grand bargain" news, this rally will run its course and stall. European banks are still arguing over the role of the ECB. The EU does not have a clue and they are moving at a snail's pace. Conditions deteriorated to the point where central banks around the globe could not wait. They had to take immediate action to avoid a financial disaster. Stocks in China fell 3.27% overnight. Their markets closed before this major news event and they had news of their own. China lowered bank reserve requirements for the first time in three years. On the surface, this seems like good news. However, they are responding to a decline in economic activity. Tonight they will release their PMI and it will decline below 50 indicating economic contraction. The US economic releases this morning were good. ADP reported private sector job growth of 206,000 in November and that was better than expected. Chicago PMI also came in better than expected. There will be major news releases before the open tomorrow. China and Europe will release their PMI's and Spain and France will hold bond auctions. Economic activity will be dismal, but bond auctions might go well now that central banks have calmed nerves. The Unemployment Report on Friday should be "market friendly". As I've been noting, I have tenuously been hanging onto my short positions. Seasonal strength is a formidable force and it is not wise to fight it. The situation is different this year and I feel the rally will attract sellers well before it gets back to SPY 130. Asset Managers that want to reduce risk ahead of 2012 will be selling into strength and that will provide stiff head wind. I am getting out of my put positions today. Nice gains turned into a small loss in three days. The S&P 500 has rallied more than 80 points in that time. This market is impossible to trade. For the remainder of the year I will be using a relatively safe strategy. I will be selling out of the money put credit spreads on strong stocks. Option implied volatilities are high and central banks have provided a safety net through year-end. Once this rally stalls, I believe an excellent shorting opportunity will present itself. That bearish opportunity should come after December option expiration. I have posted this same chart from yesterday. It shows the price action towards the end of 2007 and I believe the current conditions are similar. The market rallied into the middle of December and then it rolled over hard. This should be the final stage of the rally. I am likely to get out of my put positions today. Since the initial surge, the momentum has stalled below resistance at SPY 125. That level will hold today. I have taken the brunt of the damage right on the opening move and I will wait through the day to get out of my puts. If prices weaken substantially, I will scale out of 25% of my position. If the gains hold firm, I will get out of my puts completely and I will sell a few put spreads. It stinks to take a loss, but this move just sets up a better shorting opportunity down the line. image

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