Shorts Are Cautious – Lack of Selling Clears the Path. Very Light Volume

August 16, 2012

Not much has changed overnight and the market continues to trade in a very tight range. Volumes have declined to levels not seen since 2007.

Initial claims rose slightly, housing starts were a little soft, and the Philly Fed was weaker than expected. The economic news will be very light until flash PMI’s are released next Thursday.

Earnings season is winding down and retailers are posting results this week. The results are mixed and discounters are faring well.

Draghi’s comments from two weeks ago have temporarily reduced credit concerns. The EU promises to have the blueprint for a centralized banking system in a few weeks. Having the plan is a step in the right direction, but they still need to get unanimous approval. Many sovereigns might not want to relinquish control over their national banks.

For the time being, European credit concerns have been pacified and stocks will be able to grind higher. Asset Managers can see storm clouds on the horizon and their level of conviction is low. Even a small bid in quiet markets can push stocks higher.

This rally has more to do with an absence of selling than anything else. Shorts were scorched two weeks ago when Draghi said that substantial actions would be taken to prevent a credit crisis. The market is within striking distance of a four-year high and shorts will not get aggressive at this level. Bears also fear that the EU/ECB might actually get ahead of the curve.

At the end of the day, nothing has changed. European credit concerns can flare up at a moment’s notice. The ECB will simply support short-term interest rates if fiscal spending cuts are implemented to their satisfaction.

Greece is running into a cash crunch. They are way behind on spending cuts and revenues are declining. Even if all of their debt were wiped away, they still have enormous entitlement commitments and they will continually come back to the trough.

Spain and Italy are in dire straits. Interest rates were above 7.5% just a few weeks ago.

France is considered one of the strongest EU members and they have had 0% GDP growth for three straight quarters. Under new Socialist leadership (Hollande), corporate tax rates are increasing and companies are moving their headquarters out of the country.

This morning, Cisco provided guidance. In short, the news was better than feared. They still cite tremendous weakness in Europe.

Central banks are providing a backstop for the market. If economic conditions deteriorate, traders are willing to give the release a “free pass”. They believe that central banks will ease on weakness and that support is keeping a bid to the market.

Unfortunately, the PBOC is the only central bank with firepower. Interest rates in China are still relatively high and a cut is meaningful. The Fed, BOE, BOJ and ECB have almost run out of bullets. Previous actions have not stimulated economic activity.

Yesterday, VALE (Brazilian iron or producer) said that China’s growth may have run its course. This company has its finger on the pulse and this statement carries a lot of weight. China has been the cornerstone for global economic growth and if it falters, the growth engine is gone.

With each passing week, the November elections and the “fiscal cliff” draw closer. These events will create uncertainty and that typically translates into volatility.

Option premiums are near pre-crash levels. No one is looking for a major decline and ironically, that’s when the risk of a decline is the greatest.

For now, I suggest trading the upside. Look for stocks that are in an uptrend, have consolidated in a tight range for a couple of months and are breaking out to a new high. I referenced HD a few days ago and you can see the sustained move that results from this pattern.

This rally could last another week. Don’t look for an explosive move, just a grind higher. If we poke through SPY $142, you will see some follow through as bullish speculators pile in. Once that momentum stalls, look out. A reversal back below $142 could spark a swift round of selling.

Keep your size small, use stops and limit overnight exposure.
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