On May 19, 2008 the SPX completed an 8 week 13.3% rally after news that Bear Stearns would be purchased by JPM. After a slow grind up with plenty of back and filling markets came to the 200MA, pierced intraday and then failed.
At that point few would expect a close above the 200MA on the first try. Additionally the move off the March 17 lows was orderly and again was back and filled (i.e. prior lows tested before moving higher). That would be considered a text book market rally. Few if any would believe what came next.
Over the next two months markets would move down 16% and would take out the March 17 lows. So what was the news? Beyond rumblings of sub prime the US economy was clearly “not in recession” as the pundits would claim. Unemployment was 5.4% in May while consumer confidence was 59.8%. So what caused the market to rollover? Honestly?
Fast forward to where we are today. A truly massive 20% rally has ensued over the past three weeks. Unemployment is 9.1% and confidence is 57.5%. Is it possible to think that the following analog can continue to work? In May 2008 there was no major reason for the epic selloff other than possibly some profit taking into the summer months.
This chart has not been updated to reflect recent price action
So what is the bear case moving forward? Is there any reason to stay short or go short? Here’s a scenario that I believe many traders and investors fail to recognize as acknowledged by today’s rally. For reference please read the two prior posts Europe Behind the Scenes Part 1 and Part 2
The “EFSF Plan” may have calmed investors but I doubt it did anything other than exacerbate counter party risk. The banks that have been actively selling assets to raise liquidity have found themselves in need of more capital with the realization of both a 100 billion capital short fall plus the Greek bond haircuts. Two important things are happening right now both of which are not telegraphed.
First, no one is lending to each other across Europe as discussed previously. The EU economy is contracting. The plan of a plan has done nothing other than buy Greece some time and move equities higher. How does Greece getting some percentage of debt forgiveness make SocGen less of a counterparty risk. How did Wednesday’s press conference reduce the chance that creditors could still face their debtors in bankruptcy court to collect payment.
Second, capital calls are being made. Zero Hedge reported that what actually put Dexia into receivership of sorts was Goldman Sachs demanding capital due to counter party risk. Think back to the weekend that AIG failed. They were in trouble but had time. Then the rating agencies downgraded them resulting in higher capital requirements from lenders. What became possibly a manageable problem became unmanageable overnight. The US government was forced to step in and provide assistance.
That set off a chain of events that over the next few days would wipe out legendary financial institutions globally. Within months the US would go from .53% growth in Q2 to (3.99%) contraction in Q3 all because the financial system shutdown. It was not limited to LEH and other financials but the entire economy. The same is happening today not only in Europe but across the globe.
Someone please tell me how the press releases from the EU last evening did anything to stem this “contagion” if you will. I would argue they in fact made it worse for they did nothing to address the fundamental problem. No one wants to lend to insolvent institutions.
So where do we go from here? I do not know. No one knows. Tell me what is happening behind the scenes in Europe and I will tell you what happens next. Tell me that by killing the CDS market leaders did not actually cause sovereign yields to rise. Tell me that Ireland, Portugal and others will not demand debt forgiveness (Ireland already has started the process by the way).
I am not advocating risky actions here. This market is scary and like a steam roller just slowly and methodically climbs. There were signs of weakness internally today though. Probably the two that stood out was the Vix bottoming intraday while SPX moved higher. Most important though was AAPL up 1% while tech was up over 3%. If this was a new leg higher why wouldn’t you buy AAPL? Why would AAPL be at the top of selling on strength all day (along with the SPY). Why were the financials all up 10% or more? Tell me which stock had higher short interest.
Images: Flickr (licence attribution)
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