Tough to Fight Seasonal Strength. The Backdrop and Price Action Reminds Me of 2007.

November 29, 2011

Yesterday, the market bounced from an oversold condition. The EU is scrambling to draft policies for fiscal responsibility that would be imposed on member nations. This process will take many months and there will be a roadblock around every corner. From my perspective, nothing has changed and this rally will soon lose its steam.

A few weeks ago, I thought this decline would be temporary and it would set up a nice year-end rally. Conditions have deteriorated substantially and I feel we are on the brink of a prolonged decline. Year-end strength might get us through 2011, but I don’t like what I see in 2012.

Interest rates throughout Europe have skyrocketed. Italy held a bond auction this morning and analysts say that it “went well”. Interest rates jumped, but three-year yields stayed under 8% and €7.5 billion worth of bonds were sold. This auction might not have been catastrophic, but I would not call it good. Interest rates in Spain, Belgium and Hungary have jumped to 52 week highs as well. Credit risk is spreading to the rest of Europe.

Germany and France are EU cornerstones. Their interest rates have been climbing in recent weeks. Standard & Poor’s will likely lower its outlook on France in the next week. This is what contagion looks like.

European banks are in dire straits and Eurozone governments are leaning on them to buy government bonds. International banks are selling European assets and the liquidity is drying up. Moody’s warned that it could downgrade the subordinated debt of 87 banks across 15 countries. It feels that governments are too cash-strapped to bail them out. The ECB allotted €265 billion for refi operations and that is the highest level June 2009. Banks are running out of eligible collateral and they want the ECB to expand the terms (assets they can pledge). The bottom line is that liquidity is drying up. This is a precursor to a financial crisis.

In the US, our outlook was downgraded to negative by Fitch overnight. This was expected and it will provide a small headwind. Congress will be busy trying to extend unemployment benefits and payroll tax credits. Democrats will want to raise taxes to fund the programs and Republicans want to pay for it through spending cuts. Where have I heard this debate before? History will repeat itself and Congress will be in gridlock right to the deadline.

Many government agencies will run out of money in the next few weeks and those budgets need to be approved. This debate will also weigh on the market.

The economic news has not been good, but it has not been bad enough to spark a decline. Last week, GDP was revised lower from 2.5% to 2%. Europe and China reported weak flash PMIs. The actual numbers will be posted on Thursday. Global economic conditions are starting to deteriorate and they will only get worse as austerity programs kick in. Last week, China’s Finance Minister spoke of a prolonged recession and he said that could have structural problems within it financial structure.

Tomorrow we will get ADP employment, the Beige Book and Chicago PMI. Initial jobless claims have been pretty good the last four weeks and I’m expecting “market friendly” reactions to the jobs reports this week. However, I would caution that 100,000 new jobs in the private sector is nothing to get excited about. It might satisfy Wall Street, but it is not a bullish number. The Beige Book and Chicago PMI should be soft.

The big news will hit Thursday. France and Spain will hold bond auctions and the results will be scrutinized. Interest rates have been climbing and we will see to what extent the ECB can keep the “genie in the bottle”. Europe and China will officially release their PMI’s and I am expecting weak results. The market has already priced this in, but the actual results might remind traders that conditions are deteriorating. If the selling pressure is moderate on the open, a soft ISM manufacturing number could spook investors and this rally could roll over.

Friday’s Unemployment Report should be better than October’s number, but I would not consider it robust. We need to create 250,000 new jobs each month just to keep up with the growth of our workforce.

Year-end strength is a formidable force to fight and stock valuations are cheap. Normally, I am trading the market from the long side during this time period. I must admit it feels very strange to be short in November. I will exit put positions if this rally can follow through and close above resistance at SPY 123.

This price action reminds me of Nov 2007. The warnings signs were there, but there were no “dead bodies”. During a typically bullish period, the smart money was selling into seasonal strength. We had bounces in December and that made shorting very difficult. Late in December, the market finally cracked and 2008 was a bearish year.

The market is building on yesterday’s gains and it is grinding higher. Bulls will probe for selling pressure. If this rally stalls this morning, we could see selling this afternoon. If it makes a new high in the afternoon, it will grind higher into the close. The true test for bulls will come Thursday morning after the Euro bond auctions and the PMI’s.

If I do get shaken out of my puts, I hope the market skyrockets. That will set up one of the best shorts I have seen since this summer.
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