Sage Weekly Letter – 4/22/2012
- Posted by Robert Sinn
- on April 22nd, 2012
From my estimation markets are drawing near to a key inflection point which could arrive as early as next week with any number of potential catalysts (FOMC announcement, Bernanke press conference, 1st quarter US GDP, the usual eurozone issues, etc.) serving to ignite outsized moves across markets. I don’t want to delve too deeply into the macro minutia of the moment, however, I believe it is worth saying a few words about the two most important institutions in global financial markets: The ECB and the Fed.
By most accounts both the ECB and Fed have managed to curb markets’ enthusiasm for additional policy easing, although the recent steep declines across commodities and pullback in equities signal that market participants may require another liquidity infusion sooner rather than later. The ECB in particular appears to be playing a dangerous high stakes game of chicken with markets as Spain, and in turn the European banking system, teeters on the brink of crisis. My good friend David Schawel published an important piece on the topic of “How Spain Pays the Piper” last week in which he offers a few different solutions.
It is most likely that a combination of solutions will be needed in order to, at the very least, stave off a major crisis in Spain. First of all, the ECB will have to become actively involved in providing additional liquidity or being the buyer of last resort for sovereign debt. Two LTROs have already been done in a very short time span, therefore, I believe it is much more likely that the next step for the ECB is to engage in larger sovereign bond purchases on the open market. These purchases will either be largely ‘unsterilized’ or they will be sterilized using short term swaps which will be regularly rolled over. Either way this will serve to further balloon the ECB’s balance sheet and will be viewed by markets as additional policy easing by the ECB.
Even with additional ECB policy accommodation the problem of how to recapitalize the Spanish banks will still remain which is where I believe David’s solution #3 of debt for equity swaps and debt for equity swaps on bad loans will come into play. I expect that the refinancings and restructurings in Spain will be creative, however, current equity holders are likely to be squeezed even more than they have already. Take a look at a monthly chart of Spain’s IBEX 35 Index:
Click to enlarge
Spain’s equity market is almost back to its March 2009 low levels and thus far there is no sign of a bottom in sight. The pain within the weaker euro area countries continues to be exacerbated by the German/ECB obsession with inflation which has recently remained elevated due to high oil prices. However, the inevitable end result of high oil prices, private sector deleveraging, fiscal austerity, and an ECB that remains behind the curve will be a continued decline in aggregate demand which will in fact lead to deflationary pressures.
The fact is that policymakers and ECB officials know full well that there is far too much at stake with the ‘euro experiment’ to allow it to fail at this point. The ECB’s recent ‘tighter’ posture is a gesture of tough love aimed at inducing periphery policymakers to take some fiscal medicine before the next round of central bank blood…..err liquidity…..transfusions set in. Markets know that the ECB will ride to the rescue should (when) conditions deteriorate further which helps to explain the recent orderly declines with only the faintest signs of panic.
Meanwhile, on the home front there are growing signs that corporate profitability may have peaked and that growth was pulled forward during the unusually warm winter months. As the current “Operation Twist” winds to a close the Federal Reserve risks sending a tightening signal to markets if it does not announce, or at least hint at, additional policy easing between now and its June 20th meeting. With the risks still firmly to the downside due to the highly uncertain situation in Europe and a hard landing scenario still not off the table in China, I expect the Fed to embark on another “twisting” operation. With short rates pinned near zero for an extended period a new $400-500 billion Operation Twist would be seen as additional policy easing and would likely serve to further increase the Fed’s balance sheet (the Fed is running out of short term Treasury securities to sell, therefore, short term swaps are likely to be used to sterilize additional Fed purchases of long dated Treasury securities).
With the Fed and ECB likely to not only remain highly accommodative for an extended period, but to actually become more accommodative the following chart elicits more questions than answers:
Commodities have had a rough couple of months and the CRB Index is currently trying to hang onto important support in the 290-300 area. It seems that a combination of China & Europe slowing along with market fears that the ECB and Fed are on the sidelines for several more months have weighed heavily on commodities.
While a strong case can be made that many charts are at or near key inflection points, two charts stand out to me as being key to unlocking the macro-market story for the next 6-12 months (and perhaps longer):
US Dollar Index Weekly ($DX_F $UUP) – Like many charts this one is open to interpretation, I view the Dollar Index as most likely forming a bear flag with a weekly close below 78.10 setting in motion the next leg lower. Meanwhile, one can also make a strong argument that the Dollar Index has been forming a two year rounded bottom (inverted head & shoulders?):
If I were allowed to view only one chart of any market it would be the Dollar Index – I believe that whichever way the dollar breaks will dictate major movements and trend changes across almost all other asset classes/markets over the coming months & years. While the dollar is crucial I also believe that gold will provide market participants with a great deal of information regarding global central bank monetary policy, soundness of the global financial system, and the direction of the US dollar, etc:
Gold has been building energy for several weeks as it oscillates in the $1600s and there is a veritable cornucopia of chart interpretations and chart patterns forming in gold over various time frames. A breakdown below $1600 would give the bulls ample cause for concern, whereas, a rally back above $1730 would prompt the technicians to begin tossing out $2,000+ price targets like it was August 2011 all over again.
In summary I believe that many markets are poised for a large move, however, US equities are likely to remain a bastion of stability even in the event of storms overseas. I have put together a simple probability analysis with a fair value for the $SPX based on my best estimation of various events taking place over the next 30 days:
A deeper pullback to below the April 10th low should offer market participants an excellent opportunity to increase long equity exposure, whereas, a rally back above SPX 1400 should offer a final excellent opportunity to “sell in May and go away”.
I’m going to keep this week’s best ideas short and sweet:
- Long gold ($GLD) volatility through May straddles, short butterfly spreads, short iron condor, etc. I opened a position on Friday which will benefit from an outsized move in gold over the coming weeks.
- I continue to like last week’s stock ideas $DOW, $HUN, $NEE – NEE broke out to new all-time highs while DOW is poised to breakout above 36 with another 2 point “air pocket” above.
- There is a lot of hype about $AAPL and people claiming that the stock is about to crash etc. Although I do not have a position on yet, I will be looking to put on a May iron condor in AAPL on Monday or Tuesday (AAPL reports earnings after the close on Tuesday) to attempt to take advantage of the elevated implied volatility and pervasive fear & uncertainty currently surrounding the stock.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.blog comments powered by Disqus
Robert Sinn is a professional trader and market analyst who focuses on multiple asset classes including equities, futures, options and currencies. He integrates fundamental and technical analysis. More »