Let It Run. Wait For the Momentum To Stall – Then Get Short. Next Big Move Is Down

July 27, 2012

This has been an interesting two weeks. I expected more of a rally last week and when we didn’t get it on the heels of good news, the warning sirens blew. I’ve been tempering my bearishness as long as possible and I did not want to miss the decline. I loaded up on put positions and I bought VXX/VIXY calls. Monday morning, I felt like a hero.

The market declined early in the week and it looked as though we were going to roll over. As trading unfolded, I knew that I had to weather a round of strong earnings. Stocks rebounded and they were able to challenge the 100-Day MA with ease yesterday. I suggested closing bearish positions yesterday if the SPY was able to close above $136.

I exited all of my positions and I did not leave anything on overnight. Blank comments from the ECB sparked buying and I expected to see a pullback late in the day. When we didn’t get one, I knew we were heading higher.

The rally this morning is what I expected last week. Stocks should be able to challenge SPY $140 before running out of steam. Make no mistake, I am eager to short this market again. As it moves higher, I will raise my entry point and I plan to catch the first reversal.

From a trading perspective, the worst thing that could have happened is for me to stop out of all positions and to get a selloff today. That would’ve caught me off guard and I would be flat-footed. The decision to jump back in would’ve been difficult. At this juncture, I am no worse off and I know the next entry point will be much better.

My position size was bigger than it has been all year and that also reduced my staying power. I will be looking for signs of weakness and I will be buying puts when the momentum stalls. I will not be buying calls and I will not be day trading from the long side. I am 100% in cash and I am fully committed to the next move down.

All hope is tied to ECB/Fed statements next week. The ECB will “do everything in its power to avoid a financial collapse”. I wouldn’t expect them to say anything less. For crying out loud, the 4th largest economy in the EU is on the ropes and their interest rates spiked above 7.5%. Draghi had to say something!

The market is hoping the ECB/EFSF/SMP/ESM will start buying sovereign debt and it is expecting comments along those lines next week. There is no way that this is going to happen. Strong EU members have been opposed to the idea. In lieu of that, LTRO3 might work. Chances are it will be considered later in the year.

Spanish and Italian banks are tapped out. That means they won’t be supporting their respective bond auctions and they need help from the ECB/IMF and foreign investors. European banks are strapped with toxic assets and the ECB will have to lower collateral standards for LTRO3 to work. These banks have nothing to pledge. Even if they get money from the ECB, they might not use the proceeds to purchase sovereign debt.

There were no details behind the ECB President’s comments. It is possible that ECB will simply offer its trading desk to the EFSF/ESM. If this turns out to be the solution, the market will pullback quickly on the news. This would mean that the ECB is not participating in the bond auctions. Next Thursday, Spain will hold a bond auction and this will all play out.

Here’s the real “take away”. The ECB and the Fed have almost fired all of their bullets. Traders need the next “fix” and they want to hear LTRO3 and QE3. If they don’t, the reaction will be negative next week. Keep in mind, the ECB and FOMC won’t meet again for 6 weeks.

Once these actions are taken, the market will be looking for more. Monetary easing has not stimulated economic activity and there’s not much more Draghi or Benranke can do.

This morning, Q2 GDP was released. It came in at 1.5% and that was in line. Realize that consensus estimates have been revised downward over the last few weeks. Economic conditions are deteriorating worldwide.

Companies are running lean and mean. Profits have been preserved through cost-cutting. Three quarters of the releases have missed top line estimates. Corporations will not be adding to payrolls and I believe the jobs reports next week will be light.

Official PMI’s will be posted next week and we will also get ISM manufacturing and ISM services. Traders have been able to focus on earnings, but that will change next week. Monetary easing, European credit concerns and economic releases will dominate the scene.

The current move is a short squeeze. More than anything, hedge funds that were shorting Spain’s debt and the Eurodollar got squeezed. They covered positions and that bounce will stall very soon. On a longer-term basis, deep pockets will sell into strength and the long-term downtrend will resume.

I am in cash and I am patiently waiting for my opportunity to buy puts. At this juncture, I will buy puts if the SPY trades below $136. If the market rallies and it reaches $140, my entry point will be raised to $138. If we get to $142, I will raise my entry point to $140. I don’t mind missing a rally and I will keep my powder dry. The higher we go, the happier I am.

The risk is very high and the market is expecting miracles out of the ECB. I’m betting they will come up short.

We are seeing a little short covering today and the momentum could continue into next week. Wednesday – Friday will be VERY interesting.

The next big move is down.
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