A trader’s strategy guide to prior week’s market movers and their lessons for the coming week for traders of all major asset classes, via both traditional instruments and binary options.
- Bearish Fundamental & Technical Context
- US Credit Downgrade
- Willcommen, Bienvenue, Contagion!
- Fed Eases
- ESMA Short Selling Ban
- Technical Breakdown For Risk Assets?
- Lessons & Ramifications
The context in which last week's main market movers appeared is key, so here’s a quick review of what had been driving markets.
Steadily Worsening EU Sovereign Debt & Banking Crisis: As we’ve written about repeatedly in prior weeks’ posts, the latest EU rescue plan is backfiring badly, as reflected in the S&P 500 index from the week of July 24 onwards. While it was understood that Greece would default at some point, the understanding was that the EU would protect private bondholders (mostly the EU banking system itself) from losses rather than risk a crisis from destabilizing EU banking. For reasons beyond the scope of this article, Germany insisted that the private sector take losses. That scared credit markets and sent rates soaring on all GIIPS bonds. Predictably, this raised doubts about the stability of the banks holding these bonds – particularly banks of other GIIPS nations that were not already considered basket cases Greek banks) or wards of the EU (Ireland, Portugal) under speculative attack. Hence the plunge in Italian and Spanish bank shares, and rise in sovereign bond yields of these nations.
US Debt Ceiling Policy Paralysis: Until two weeks ago it was assumed the US could both raise its debt ceiling and in the process begin cutting its deficit in a timely manner and avoid fanning fears of both a default and continued unrestrained deficit growth. Then in the week prior to the August 2nd, as the deadline to raise the debt ceiling approached, it became clear that its political system may be too deadlocked to do either.
Slowing Global Growth: Data from every major economy had been showing a consistent theme of slowing growth that made it difficult to justify market prices within about 10% of all time highs, especially with no sign of further stimulus from the Fed or other major central banks that had enough cash to make a difference.
Technical Analysis Via The S&P 500 As Barometer Of Risk Appetite
As of the start of the past week the index had shown a classic Head and Shoulders pattern. After falling about 100 points from its roughly 1360 high of early May to the neckline (the middle blue line – the low between the two shoulders at around 1260) and breaking that support level, the index did what market technicians expected it to do and fell an equal distance from the high to the neckline, another 100 points, to about 1170.
S&P 500 WEEKLY AS OF THE START OF THE WEEK OF AUGUST 8TH 2011 CHART COURTESY ANYOPTION.COM 06 aug 14 0146
Here’s what then happened in the past week.
S&P 500 DAILY CHART AUGUST 8-12 2011 07 aug 14 0200
The index plunged from around 1200 at the start of Monday trading to close near support of 1100, and then gyrated wildly within this range the rest of the week to close only an additional 1.7% lower at 1178.
What were the fundamental drivers behind these charts, and what lessons do they hold for the coming week?
S&P Downgrades US Credit From AAA to AA+
After a bitter fight, the White House and Congress reached a last minute compromise to raise the debt ceiling and cut the deficit by around $2 trillion vs. the $4 trillion originally expected. (This, vs. the $8-12 trillion most believe needed to actually get the US deficit meaningfully lower.) Like most observers, S&P believed this was not a serious attempt to reign in the deficit. Unlike the other major other ratings agencies (Fitch and Moody’s), S&P took the political deadlock more seriously, saying that failure to bridge differences and address default risk without 11th hour dramatics was unbecoming of a AAA rated nation. While it was unclear if the downgrade had much practical near term effects, the uncertainty alone, given the above bearish fundamental and technical outlook, was enough to spark heavy selling. Contributing to the selloff was…
Fears Of Further EU Deterioration French Credit Downgrade & Bank Solvency
With Spain and Italy already known to be in trouble, the S&P downgrade raised questions about whether France too could be downgraded given that its banks are so heavily exposed to GIIPS bonds. As was the case with Ireland, this is a huge problem for France because the assets of a number of its largest banks exceed French GDP, and a large chunk of those assets are in GIIPS bonds. (French bank exposure to Spanish bonds alone is equal to about 20% of French GDP.) After all, how could the S&P claim impartiality if the US lost its AAA rating yet France retained theirs?
Shares of French bank stocks were creamed on rumors of instability. Though these were denied, the damage was done. There were reports of Asian banks now cutting off overnight lending to French banks, and the 6 largest US money funds also stopped buying short term French bank debt.
Each day brought news of trading suspended in assorted Italian stocks, banks in particular, to stem their collapse.
Even after rumors of a French downgrade died down, the ECB’s purchases of Spanish and Italian bonds did not calm markets early in the week. French sovereign bond yields soared to all time highs, with investors demanding an additional 90 basis points to buy French 10 year bonds rather than those of Germany (vs. the 2010 average of 33 bps), even though both are AAA rated.
Markets were in disorderly retreat Monday and for much of Tuesday until the FOMC meeting and rate statement 2pm EST, after European markets had closed. Key points included:
- The Fed would keep rates exceptionally low until at least mid-2013
- While not openly signaling QE3, the change of language in the ‘extended period’ phrase, maintenance of the reinvestment program, low inflation expectations and discussion of “the range of policy tools available to promote a stronger economic recovery in a context of price stability” suggested that the Fed will resume outright asset purchases, if needed. The next key event would be Fed Chairman Ben Bernanke’s speech at Jackson Hole on August 26th. Many believe that the Chairman will announce further easing then, as he used this event to announce QE2 last year.
ESMA Short Selling Ban
On Thursday, the European Securities and Markets Authority (ESMA) announced a short−selling ban of specific stocks by four countries including France, Spain, Italy and Belgium. The move was believed to have been the fuel behind Thursday’s rally. The history of such bans suggests they have little lasting impact. In addition, because many of the protected shares were banking stocks, there’s a chance that those seeking to short the financial sector might just short banks of other nations instead, given that there are no shortage of banks with significant GIIPS exposure, direct or indirect.
Charts Show Technical Breakdown For Risk Assets
From a technical perspective, the rally that began in the summer of 2010 has been lacerated. Deep wounds like that of the past weeks take time to recover from, barring some major bullish change to fundamentals. Support around 1100 on the S&P 500 has held for now, and as we discuss below; there are reasons to believe we could see a short term bounce (longer if/when new QE is announced). However the charts for the S&P 500 and other risk barometers look terrible. For example, look at the weekly chart below.
S&P 500 WEEKLY CHART COURTESTY ANYOPTION.COM 12aug 14 0412
The key points to note include:
The index is deeply embedded in its Double Bollinger Band Sell Zone. For those not familiar with use and interpretation of Double Bollinger bands, see 4 RULES FOR USING THE MOST USEFUL TECHNICAL INDICATOR, DOUBLE BOLLINGER BANDS. The same holds of course for the daily chart.
Note in the weekly chart above that the index has also breached its 200 week EMA (pink). Unless the index can rally back above this level around 1200 soon, then we’re looking at a decisive break below this level. As the below long term weekly chart of the index shows, breaks below this level usually bring longer term pullbacks.
S&P 500 WEEKLY CHART JANUARY 2001- AUGUST 2011 COURTESY ANYOPTION.COM 13aug 14 0421
As shown on the chart below. We’ve got a growing death cross on the daily chart that began August 10th. A death cross is when the 50 period EMA (red) crosses beneath the 200 period EMA. To erase this very bearish indicator we’ll need a rally back up near 1300 soon. See our special report on this here for details.
S&P 500 DAILY CHART & DEATH CROSS HIGHLIGHTED COURTESY ANYOPTION.COM 14 aug 14 0431
Lessons & Ramifications
Long Term Bearish On Risk Assets
The picture from both a fundamental and technical perspective is distinctly bearish. The above mentioned fundamental problems remain.
No Solutions, Just Short Term Band-Aids
On both sides of the Atlantic we see no evidence of anything beyond short term fixes and muddling through as a matter of policy. Meanwhile market confidence gets further undermined and sovereign debt remains unsustainably high.
The US debt deal’s spending cuts of ~ $2 trillion vs. the $4 trillion originally expected and $8-12 trillion needed to make serious progress on the US deficit were a joke, as was the rather short term raise for the debt ceiling.
As for the Fed’s latest indication of easing, while markets took the news of Fed easing as bullish, beyond the short term it is anything but that. Continued exceptionally low rates encourage banks to borrow from the Fed for free, and use the cash to buy risk free US Treasury bonds at 2-4% risk free rather than lend to private borrowers who could actually stimulate real growth in jobs and spending. Low rates also deprive savers of any real return and keep the value of the USD in decline.
Don’t like what markets are saying – so ban short selling? Please. It hasn’t worked in the past and reeks of sheer desperation.
Coming Weeks Could See A Rally
If there is no really bad news in the coming weeks, a bounce back up to the neckline of the S&P 500, about an 8% gain (and similarly for other risk assets), is possible. Here’s why:
- ITALY AND SPAIN: The ECB has been successful for now in stopping short speculation and stabilizing Spanish and Italian government bond markets, with 10-year yields for both back below 5%. If the ECB keeps up its debt buying for the coming months it may succeed in keeping speculators at bay.
- FRANCE: We note the credit rating affirmations and stable outlooks from the major ratings agencies. If the GIIPS can stay quiet, credit availability for French banks could improve along with their share prices.
- US FED ADDITIONAL STIMULUS : The Fed has taken the unprecedented step of promising near zero interest rates for the next 2 years, until mid-2013, and this should remove any uncertainty that the Fed might hike rates soon.
- OTHER CENTRAL BANK STIMULUS: Fed’s action makes it easier for other major central banks to cease additional tightening in response to slowing growth.
Short term traders can try to go long. For longer term investors, this would be a chance to sell risk assets once the rally fades. All bets are off if major new stimulus programs are announced. Look to the US Jackson Hole conference in late August for new US QE announcements.
While we see the longer term bear in place for risk assets, a few caveats:
- Forex: Beware shorting the USD: While a risk rally would bode ill for the USD, speculators have been cutting back short positions against the USD per The CFTC’s most recent report.
- Oil: Recent pullbacks are likely buying opportunities for oil & related assets: Per a Deutsche bank report, there have been surprisingly large Q2 drops in oil production at more than 20 major oil companies, even accounting for lost Libyan production, and these are not likely to be offset by unconventional deepwater or shale E&P projects. Wall Street will need to ratchet down its estimates, and oil prices could rise to $120/barrel.
- Gold: Despite gold’s sharp rise, any kind of QE3 announcement would likely send it higher still, as will any signs the EU is monetizing GIIPS debt. As high as gold appears, there is no change in the fundamental drivers to suggest we’ll see significant pullbacks. Adding to positions on dips to its 20-50 day EMA has worked well since late 2008.
Disclosure/disclaimer: The above is for informational purposes only, responsibility for all trading decisions lies solely with the reader. If we really knew what would happen, we wouldn't be telling you for free.