Vikram Saxena's  Instablog

The equity markets reversed course today in another dramatic session. North Korea shocked the world (at least according to the head-lines) by testing a nuclear device which actually worked. This lead a flight to safety in the overnight market with the US Dollar getting a strong bid and with the EUR-USD trading as low as 1.386 down from its close above 1.4. The equity markets gapped-down open but continued to rally up from the open.

Consumer Confidence Lights a Fire

The initial rally in the equity markets was not unexpected. The markets had sold off hard into the close Friday as traders did not feel comfortable holding long positions over the long weekend. The gap-down open gave traders an opportunity to re-initiate the long positions.

However what lit the spark was the biggest gain consumer confidence since 2003; it came in at 59.4, well above the consensus of 42.6. The market ignored the worse than expected Case-Shiller Home Price Index numbers, and of course Kim Jong-Il’s nuclear test.

Underneath the Consumer Confidence Numbers

The consumer confidence was led up by its future expectation’s component, with the expectation measure rising to 72.3, the highest since December 2007, while the gauge for current conditions was at 28.9, higher from last month’s reading of 25.5, but a far cry from future expectations.

The divergence between the two components of the consumer confidence number, mirror the equity markets very well. Though current conditions are nothing to write home about, the expectations for the future are driving the market higher. However, the risk to these green shoots remains high.

The yields on long term treasuries continued to rise today. The reduction in mortgage payments is a key pillar of the Fed’s strategy for recapitalizing the American consumer. The expectations are that lower mortgage servicing burden, will allow the consumer to spend even under times of reduced credit availability. However, that experiment is likely to fail if yields continue to rise, since mortgage spreads are near historic lows and any rise in treasury yields will affect the mortgage rates.

Risk Tolerance Returns

The equity markets were led by the small cap Russell2000 and the technology heavy Nasdaq100. The longer dated treasuries were sold, while the US Dollar lost most of its earlier gains, closing almost unchanged.

This was in a sharp contrast from last week, when equities were being sold, even when the US Dollar was collapsing against. The positive correlation between the Euro and US Equity market returned today, perhaps indicating a more subtle approach to selling US based assets, compared to the indiscriminate selling of the previous week.

My Portfolio

I continued to stay primarily in cash and day-trade. I was able to close out my short Euro positions at a profit, while I continue to hold the bearish put spread on the TBT, perhaps in the vain hope that the long bond yields will pull back to allow the green shoots to grow.

Tomorrow’s Outlook: 200 Day Moving Average

The holiday shortened weeks typically have a bullish bias. The market was oversold coming into the open today and was bought right from the get-go. Typically, the day after a strong trend-up day also has a bullish bias, especially at the open. This is primarily due to trapped shorts that capitulate the day after the trend-up day has shredded their position.

I do not expect another ripping day either after such a strong rise. We are likely to remain range-bound tomorrow, unless of course the existing home sales data surprises to trigger another rally.

The other big factor affecting the market is the looming presence of the 200 Day Moving Average of the SPX at 934.36, well in the striking distance from today’s close of 910.33. A positive catalyst will send the SPX to this critical level.

What happens at that level is going to be an important factor in determining where this market goes. If we break through this level on a convincing basis, it is likely that the SPX will hit 1000 or even higher. There is also the chance that the market will sell-off after it hits the 200 Day SMA, and start the long awaited, but still nowhere to be seen, correction.

The Friday before a long-weekend is a low volume day and there can be a lot of volatility and quick price movement. The equity markets were range bound but sold off strongly at the end of the day, showing the re-emergence of risk aversion. The risk-aversion is originating from the currency and the treasury markets. Some stability in those markets next week will likely help the equity markets find their footing. However, if the appetite for US based assets continues to collapse, the equity markets are likely to follow. 

The world markets got a shock today with S&P lowered its outlook on Britain to negative from stable, a signal that the sovereign AAA ratings may be cut. The primary reason cited was the debt/GDP ratio passed 100%. The market soon acknowledged that the US also has the same risk. This resulted in a sell-off across all US assets. The USD fell across all currencies by almost 1%. The long treasury bonds fell by 2% and the equity indices shedding 1.5-2% across the board.

Fed Intervention leads to Treasury Collapse

The Treasury bond prices collapsed after the Fed came to the market to buy US treasuries under its Quantitative Easing policy. However, the market was disappointed by the amount of bonds purchased; bonds worth $45B were offered but the Fed purchased only $7B.

Government Interference and Unstable Markets

This is another indication of how government interference leads to unstable markets. The expectation of Fed intervention has led to many (including me) to buy bonds, under the assumption that the Fed will try its best to allow the green shoots to grow by keeping the cost of borrowing low. However, once the natural balance of the market is interfered with, any unexpected event can result in a rush to the exits. Today the ratings challenge led many to sell to the Fed and when the Fed could not buy it all, prices just collapsed.

Equity Markets: Range Bound Trading Continues

As I had alluded to, the market seems to have found a trading range between 875 and 930 on the SPX. After being repelled by the upper end of the range yesterday, the market found support at the lower end today, nicely rebounding into the close.

The morning’s job loss numbers came better than expected but continuing claims did not pause. This disappointed some bulls who were hoping to see a further drop in jobless claims. Coupled with the weaker dollar theme, the market was under pressure throughout the day. Gold was up on weaker dollar and is enjoying a nice bull run.

My Portfolio

I continue to day-trade without opening any new positions long or short. Today the IYR traded in a wide range, and I sold some of my puts during the weakness, only to buy them back on market strength. The debacle in the TLT today reaffirmed my decision to close out the bulk of my position last Friday; better to be lucky sometime.

Short the Euro

After the Euro breached 1.390 mark against the USD, I opened a small position going short the Euro and long the USD. This is a contra-trend trade, where I will keep tight stops (< 1.0%). I do believe that the four day collapse in the dollar is over-done to some extent, and there is likely to be some profit-taking and risk reduction before the long weekend.

On a more fundamental basis, I believe that the Euro zone is in a much tougher situation than the US, and the ECB does not have the sovereign power to respond appropriately. The Euro-Zone will have to follow policies similar to the US Fed. They will just do it later than needed, when the situation is even worse. So even though I am bearish on the US Dollar versus the commodity currencies (AUD, CAD, NOK), I am even more bearish when it comes to the Euro versus the rest.

Tomorrow’s Outlook

I continue to expect equity markets to trade range bound, with a slightly bullish bias. We had two days of strong price losses, and we are due for a rebound, especially going into a holiday weekend. I expect a pause in the dollar’s slide and the treasuries to get some bid.