Soft Economic Data Should Be Offset By Central Bank Easing. Thursday Should Be Busy.

July 2, 2012

Last Friday, the market staged one of the biggest rallies of the year. EU officials agreed to directly aid struggling banks using funds from the EFSF. Prime Minister Merkel had been steadfast against this and perhaps Germany is starting to “soften” its stance. This decision surprised the market and shorts got squeezed.

EU member nations still need to vote on this, but it should pass. From my perspective, this is nothing more than another Band-Aid.

Economic conditions are deteriorating and Europe is already in a recession. PMI’s were released over the weekend and they will were well below 50. In fact, most of the countries came in around 45 and that indicates economic contraction.

Interest rates in Spain and Italy are at perilous levels. The risk of default is getting priced in.

Eurocrats will disappear on vacation and credit concerns will escalate in coming weeks. This pattern occurred in 2010 and 2011. The table is set for a repeat performance.

Economic conditions in China were slightly better than expected. Their PMI came in at 50.2 and many analysts expected it to drop below 50. A Wall Street Journal article pointed out that commodity inventories are growing in China. This could be a sign that manufacturing activity is contracting.

This morning, ISM manufacturing dropped to 49.7. That was much worse than the 51.5 that was expected and this is the first time in two years that it has dropped below 50. The economic calendar is light tomorrow and trading volumes will plunge into the 4th of July.

On Thursday, ADP, initial claims and ISM services will be released. Initial claims have been creeping higher and private-sector employment will be soft. Analysts are expecting 105,000 new jobs in June. I believe that number is high and we might be set up for a small disappointment. I believe the number will come in around 70,000.

On Friday, the Unemployment Report will be released and the consensus estimates project that 100,000 new jobs were created in June. The market should be able to shoulder anything above 70,000, but I believe we will be lucky to hit that level.

Central banks are easing and the BOE and ECB will meet on Thursday. England is expected to announce a $50 billion quantitative easing program and many analysts believe that they will lower bank reserve requirements. The ECB is likely to launch LTRO3 in coming months. The combined news will temporarily support the market.

After Friday’s huge run-up, I don’t know how much “gas is left in the tank”. I was expecting a couple of positive days into the Fourth of July. The SPY is right up against major resistance at $136 (100-Day MA and horizontal resistance). Dismal economic releases should be offset by central bank easing this week. However, I wouldn’t be surprised if we pulled back a little.

Earnings season has been bullish for 12 consecutive quarters. The strongest companies release early in the cycle and Alcoa will post results on July 10th. Optimism builds quickly and we could poke through SPY $136. That will spark a round of short covering and the market will quickly hit resistance.

Earnings estimates for the S&P 500 have only declined .8% (less than $1) and analysts are expecting $104.55. I believe that number is way too high. Pre-announcement warnings for Q2 are much higher than they were for Q1. Corporations are nervous and capital expenditures will be low.

Once the earnings rally stalls, I believe we will be set for a substantial market decline (15%+). European credit issues have not been resolved and the stakes are higher than they’ve ever been. Spain and Italy are 10 times the size of Greece. Combined, they are bigger than Germany in terms of GDP. Respectively, they are the fourth and fifth largest economies in the EU. Yields have reached dangerous levels and most analysts feel they have reached the “point of no return”.

Economic conditions in the US and China are contracting. Earnings estimates have not been adjusted and the projections are too high. Option implied volatilities are low and so is fear. These factors will all contribute to the decline.

For now, wait patiently. If we get a decent little pullback this week, try to sell a few out of the money put credit spreads. This will give you something to watch (keeps me from doing something stupid) and you’ll be able to generate a little income. Ideally, the market will break through resistance. That would provide us with an excellent entry point for put purchases.

Trading volumes will be light this week and the price action will be very choppy.

KEEP YOUR SIZE SMALL.
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