I sure need to repeat myself: the market isn't going straight down. To reiterate, while the S&P 500 and its tracking exchange traded fund SPY have rallied nearly 20% from the lows of last year, and stocks such as Apple (AAPL) are up nearly 30% over the course of the last year, the recent sell-off has been brutal.
While the S&P 500 has held up fairly well, declining by nearly 10% in the last several months, leading cyclicals stocks, such as GE (GE), Caterpillar (CAT), and Citigroup (C), have sold-off over 15%. Energy stocks such as Exxon Mobil (XOM) and Chevron (CVX) have been weak as well.
Still, the recent rally has been impressive. With the EU announcing what is likely to be the first of several major bailout of the Spanish banking system, and improving trade data in China, the market has rallied for three straight weeks.
I recently wrote in my article last week that I thought the rally would continue this week because of a likely favorable outcome in the Greek election, still heavy short interest in the market, and a likely short-term peak in fear levels. While all traders have good calls and bad ones, this call was correct. Still, despite the recent rally, I think the market will have trouble moving higher in the near term for several reasons.
The first reason the market rally will likely end this week is because the EU has still failed to take any real actions to truly address the Euro-Zone's debt woes since the Spanish bailout. While the conservative party's victory in the election was positive for the market, with 8 out of 10 Greeks clearly saying they want to stay in the EU, the outcome was not that unpredictable.
Spanish and Italian bond yields continues to rise, and Spain's 10-year bond is still trading above 7%. While I do believe the recent Spanish bailout will be the first of several bailouts the ECB and EU will engineer over the coming months, it is unlikely the ECB or EU will take new, more aggressive actions, near term. The EU originally funded the European Financial Stability Fund with $250 billion euros, and boosted the fund to $440 billion euros in the fall of last year. The ECB can also leverage this fund.
Still, the Spanish government had to recently delay an audit of Spanish banks until September, and the EFSF will likely need significant additional capital to bring the PIIGS long-term borrow costs down significantly. I also question the policy of buying the debt of the PIIGS, rather than recapitulating the banks, and writing off the bad loans, as the U.S. did with TARP. Germany recently talked about increasing the EFSF to $2 trillon, but its not clear where that money would come from, and the ECB lacks current authority to print money for growth or stimulus purposes.
The second reason the market rally will likely fail this week is that the Fed will not likely discuss QE3. While the Fed may ease specific rates to encourage lending, its unlikely the Fed would take or hint at the need for dramatic action when Bernanke has repeatedly said the economy shows no signs of reentering a recession, and Obama likewise continues to insist the economy is still growing. While the Fed may cut the discount rate, the market's recent rally has likely priced in at least a moderate rate cut by Bernanke.
The third reason the market will likely begin to decline this week is because of the strength of the dollar. While the dollar has sold-off during the recent three week rally, the euro failed to hold its early week gains as Spanish and Italian bonds spiked, and the dollar has held its mid-May support levels.
While the dollar and the market have been heavily correlated over the past year, leading commodities, such as oil, have traded in close correlation with the dollar for the last several weeks. With tensions in the Middle East easing as Iran is now cooperating with international authorities on its nuclear program, and China and India growing increasing slower, a strong dollar is likely to put continued pressure on energy prices. Obviously, a number of market leaders, such a Apple , GE, Citigroup, and JPMorgan (JPM), also get significant revenues from Europe, and benefit from a weak dollar.
To conclude, while the market rally has been impressive, the market is unlikely to have catalysts to continue to rally in the near term. With the Fed still being cautious, the EU moving slowly to address the PIIGS debt problems, and commodities rallying very little during the past couple weeks, the market will likely sell-off later in the week unless the Central Banks and Government leaders take new and more aggressive actions.