All Clear. Market Should Grind Higher Next Week. Traders Believe the ECB

September 7, 2012

The market waited patiently for Draghi to provide details on his bailout plan and he did not deliver yesterday. We heard the same information and the market didn’t care. It believes the ECB is fully committed and European credit concerns have subsided as a result.

He said that the ECB will purchase short-term sovereign debt if fiscal spending is controlled. Member nations still have to apply for aid with the EFSF. Spain has not formally requested a bailout because it does not want to lose control of its fiscal spending. Many analysts believe that Italy will be asking for aid by the end of the year.

In December, the ECB launched its LTRO plan. Banks were able to pledge collateral and they would use the proceeds to buy short-term sovereign debt. This maneuver had great appeal initially and the market rallied. After a few months, PIIGS interest rates started to climb and the plan failed.

I believe this plan has greater “staying power” because it is backed by the ECB. However, it will fail as well. Structural deficits will drag Spain and Italy further into debt and entitlement reform is not being discussed. These countries will have to issue more and more debt and it will become increasingly more difficult for the EFSF to hold down interest rates. It will also be difficult for Spain and Italy to comply with budget targets as deficits grow. The rhetoric will become heated and strong nations will not want to fund the EFSF.

Bad loans and toxic assets have not gone away; they have simply been shifted to “deeper pockets”. The ECB has allowed European banks to pledge low-quality collateral and the central bank continues to lower its standards. The ECB/EFSF already holds mountains of PIIGS debt.

This Ponzi scheme has reached the final stage. The stakes have never been higher and now that the central bank is backing interest rates, conditions could stabilize for a few months. When yields start to climb they will not reverse.

China’s economy is fading quickly. Traders still believe that the PBOC can reverse the trend. That means that weak economic releases will temporarily get a “free pass”. Hyper growth leads to excess capacity and prolonged contraction. I believe China is headed for a hard landing. This could be the next obstacle for the market.

Regardless of who is elected, the fiscal cliff will weigh on our economy in 2013. Some analysts believe that if all of the spending cuts are made our GDP could decline as much as 5%. It is safe to say that with some of the cuts we will still be in negative territory.

The Unemployment Report today was a little light. The market took the number in stride and traders are focusing on the strong ADP and ISM Services numbers from yesterday

The calendar is light next week and there are not many news events. The FOMC statement won’t provide any surprises. This means the market has a clear path higher.

Now that credit concerns in Europe have subsided, we are back in “risk on” mode. Asset Managers who are under allocated will play catch up. They will look for laggards and that bodes well for basic material/commodity stocks.

I am buying calls on stocks that have been in an uptrend and have consolidated during the last two months. Now they are breaking out to new relative highs.

This rally is a little overheated so look for it to take a little breather. After a day or two, it will continue to grind higher.

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September 6, 2012
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