Economic Conditions Are Starting To Slip. Start Lining Up Your Shorts!

July 15, 2010
Author: Peter Stolcers, Founder of OneOption

This week, earnings season kicked off. Alcoa sees steady demand for aluminum and CSX is forecasting growth across all of its rail transportation segments for 2010. The market liked the news and it rallied on Tuesday ahead of Intel's number. The tech giant did not disappoint and it posted its strongest quarter - ever! This set the tone for tech stocks and the market pushed opened higher yesterday. That rally lasted until the FOMC released its statement. The Fed lowered its GDP forecast for 2010. Fed officials concluded that the "economic outlook had softened somewhat." Half of the Fed officials saw "risks to growth as having moved to the downside." Those concerns were validated by the economic statistics released this morning. The Empire Index fell to 5.08 when analysts had been expecting a reading of 18. The Philly Fed dropped to 5.1 when analysts were expecting 10.1. These were dramatic declines. I believe that last year, inventories were drawn down to unprecedented levels and much of the recovery has been tied to that cycle. Earlier in the week, wholesale inventories grew and sales dropped. The rebuilt has run its course. Yesterday, retail sales fell .5%. This was the second consecutive month of weakness. Unemployment benefits and severance packages are running out and consumers are tightening their belts. Without question, domestic economic conditions are slipping. Durable goods fell 1.1%, Q1 GDP was revised down to 2.7%, ISM manufacturing declined and ISM services rolled over as well. Europe is weak and all hopes of a recovery are pinned to economic strength in China. Today, China lowered Q1 GDP estimates to 10.3%. That double-digit growth is excellent, but analysts had expected 10.5%. Considering that initial estimates were 11.9%, this is a significant downward revision. China is trying to cool off its economy and it could raise rates. Last week, South Korea and Indonesia raised interest rates. China could also let the Yuan float by as much as 5%. This would reduce exports and slow down their economy. They have already raised bank reserve requirements a number of times this year. The market can deal with an economic slowdown. Stock prices will gradually adjust as new data becomes available. On the other hand, the market cannot deal with a credit crisis. Once fear takes over, investors scramble to get liquid and assets plummet. Banks cease lending and counterparty risk locks up the whole financial system. This is the wild card that could surface in the next 6 to 12 months. For the time being, investors are willing to lend money to PIIGS. Portugal, Spain and Greece had to pay higher interest rates this week but they were able to secure loans. This has temporarily calmed nerves. The ECB is getting ready to pull its €442 billion credit facility. Before they closed the window, Spanish banks grabbed €126 billion (28%) of the pot. These credit conditions are very tenuous and they can change in an instant. Debt levels in Europe (and the US) are at extreme levels. Austerity programs have done little to address the true problem (retirement benefits, social programs, health care spending) and the deficits will continue to escalate as the population ages. It's not a matter of "if", is a matter of "when". During the last three quarters, stocks have rallied ahead of earnings season and into the first two weeks. Excellent results get priced into stocks ahead of the release and the stocks get toppy. As earnings season progresses, stocks retreat. In each of the last three quarters, that ensuing decline has been more severe. I believe this rally might push higher next week, but then the upward momentum will stall. Intel is one of the best companies in the world and if it can't generate excitement, nothing will. Tech has to lead the market higher because healthcare, energy, financials, retail and real estate are all struggling. After the close today, Google will release results. This should keep the market from a deep selloff today. We have heard from some of the strongest companies (CSX, INTC, GOOG, and JPM) during the first few days of earnings season. In coming weeks, the guidance will not be as robust. I believe the market still has one good push left in it. Resistance at SPY 112 should hold and there is a slim chance we could rally to SPY 115. I am currently on the sidelines waiting for resistance. Each day I am evaluating stocks on a sector by sector basis and I am looking for weakness. By the middle of next week, I will gradually start buying longer term out of the money puts. The VIX has dropped to a level where options premiums are fairly reasonable. I know I am early to the party and I am prepared to take some heat. I don't want to miss the move and I know that when the decline starts, option premiums will jump and bid/ask spreads will widen out. I believe the next move lower will take place in late August and September and the market will fall below SPY 100. image

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