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The stock market broke out to a new five and a half year high last week. European credit concerns have subsided and traders have full faith in the ECB’s commitment to financial stability. The last two times peripheral yields declined, the market staged sustained rallies.
The underlying problems still exist, but the market doesn’t care. The ECB can suppress short-term interest rates, but structural deficits will eventually test their mettle. Until entitlement programs are reformed, debt levels will continue to grow. Spain and Italy will need new bailouts and it will be increasingly more difficult for the ECB to keep a lid on interest rates.
Yesterday, the IMF said that Italy and Spain have “done enough already”. They support current austerity measures and the IMF has $1 trillion in its slush fund. Spain and Italy have not officially asked for aid from the EFSF because they don’t want to lose control over fiscal spending. They might knock on the IMF’s door.
Germany will vote on the legality of the ESM. Even if they vote it down, other provisions have already been made (EFSF) to stabilize sovereign credit markets. This would simply be a temporary setback.
This morning, Moody’s said that it will downgrade US debt in 2013 if politicians can’t reduce deficit spending. Our national debt is greater than that of the EU. The fiscal cliff is approaching and politicians will try to wiggle their way out of the noose. If they do, we will lose our credit rating. On the other hand, if all of the spending cuts are made, some analysts believe our GDP could decline by 5% in 2013. Either path presents problems.
China’s economy is starting to slip and I believe they are headed for a hard landing. Their economic releases yesterday (retail sales and industrial production) were soft. This morning we learned that consumer lending increased more than expected in August and that is a small positive.
The dark clouds I mentioned will stay on the horizon for the time being, but it’s important to realize that they can roll in at any time.
Bond yields are at historic lows and stock valuations are attractive. Asset Managers are under allocated and they want to rotate out of fixed income and into equities. As long as European credit concerns are pacified, they will remain in “risk on” mode. Money Managers don’t want to miss a year-end rally and they will bid aggressively. That means that every dip is a buying opportunity.
I have shifted my short-term bias to bullish. As long as the SPY can stay above $142, buy calls. Look for well-managed companies in sectors that have lagged the market. These will be particularly attractive to Asset Managers playing catch-up.
The news is very light this week. I’m not expecting any surprises from Europe or the FOMC. As I said before, any pullback will be brief and it will represent a buying opportunity.
There are many issues that will weigh on the market in coming months. I am buying fairly aggressively at this level and I plan on taking profits over the next two weeks. This final surge could be short and swift.
Look for positive price action this week.