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Stock World Weekly: Europhoria

Stock World Weekly: Europhoria

Excerpt from Europhoria, the week ahead section:

The markets enjoyed this week’s eurozone announcement, with its expansion of the EFSF, the 50% “haircut” for Greek bondholders, and the recapitalization of European banks. But the Europhoria was not universal, and many remain skeptical. For a well-done glimpse into the inner-workings of the eurozone’s latest plan, watch this Xtranormal cartoon. Zero Hedge’s take: “While it is not the bears doing the explaining in this latest all too realistic summary of the European non-bailout, it is the next best thing.” We agree; we cannot find a better way to communicate the pure confusion.   

One obvious problem is the political and financial fallout from the “voluntary” 50% haircuts being agreed to by Greek bondholders. Now that Greek bondholders have been shorn, what will keep Italy, Spain and Portugal from asking for the same deal to help them out of their debt obligations? German Chancellor Merkel is already warning against this. She declared, “In Europe, it must be prevented that others come seeking a haircut.” It is possible that the finance ministers of the eurozone have accomplished nothing more than to prevent fiscal contagion by exchanging it for a pandemic of debt forgiveness, as nation after nation lines up to ask their creditors to similarly accept 50% haircuts or perhaps even more. 

If these bondholder haircuts are deemed “voluntary,” then their credit default swap (CDS) insurance won’t pay out, because the event would not be considered a default. How this strategy will play out remains unknown. Jennifer Lee of BMO Capital Markets surmised,“Enthusiasm, so evident yesterday with the huge market rallies seen around the world, appears to have taken a backseat to the question ‘How on Earth is all of this going to work?’ The details, or the implementation of the grand plan, will be extremely difficult to carry out.”(Indexes in idle mode: Stock rally fed by Europe deal slows) 

Lee Adler of the Wall Street Examiner closely follows the Federal Reserve and Treasury markets. He recently wrote to subscribers,“Investors sold Treasuries and bought stocks this week. The Treasury market took some heat due to a big slug of new supply, and a continuing buyers’ strike by foreign central banks (FCBs). $48 billion in new Treasury supply settles on Monday. It’s not clear whether there was enough liquidation of Treasuries last week to cover the bill. I suspect not, given that it looked like all of the cash was dumped right into equities. The dealers may still have a ton of Treasury inventory to get rid of, especially the 7 year note auctioned at the peak of the carnage on Thursday.   

“FCBs are in a short term cyclical upturn in their buying pattern, but this turn comes from an unprecedented level of weakness and the numbers coming off the low are pathetic, and still deeply negative. If this is the up phase, I can’t wait to see the next down phase. It will be ugly. But we probably will not have to deal with that for at least another 6 or 8 weeks if typical timing holds for this buying cycle.  

“On the other hand, unless the FCBs step up to the plate much more than they have in the past couple of weeks, either the Treasury market will collapse, or the stock market rally will fizzle, or both. We’re not there yet, but if these trends continue, make no mistake, the balance will tip. For the time being, the theme of one market rallying at the expense of the other can continue, but that’s a limited term proposition. Once the FCBs go into their next normal retrenchment period, probably around the turn of the year, the situation should deteriorate. The rise in yields will become intolerable, and stock investors will probably start liquidating as a result. At that point, the Fed would be forced to step in to attempt to stave off financial collapse.” (The Treasury Market Will Collapse)

Summarizing his outlook for next week, Phil wrote, “We take a series of BALANCED trades – SELLING as much premium as we can so that time (theta decay) is always on our side. We take our profits off the table and, when we have to, we take our losses. However, we try to adjust the losing sides of our positions with the expectation that the markets will remain in a trading range and make the occasional reversals. We continue to play that range while the Big Chart is below the +10% lines. We will get MORE bearish as we move higher but we BALANCE our trades. Our bearish expectations are based on possible Yentervention by the BOJ, negative analysis of the EFSF over the weekend, and LACK of additional stimulus by the US, China and Japan to match the strong but Globally inadequate EU contribution.”

JW Jones's of OptionsTradingSignals shared his perspective with us. “In addition to the unknown factors impacting the European ‘solution’ next week the Federal Reserve will have their regular FOMC meeting and statement. There has been a lot of chatter regarding the potential for QE III to come out of this meeting. While I could be wrong, initiating QE III right after the Operation Twist announcement would lead many to believe that Operation Twist was a failure. 

“With interest rates at or near all time lows and the recent rally we have seen in the stock market, it does not make sense that QE III would be initiated during this meeting. It is possible that if QE III is not announced the U.S. Dollar could rally and put pressure on risk assets such as the S&P 500 in the short to intermediate term. If this sequence of events played out, a correction would be likely.”

Our trade ideas this week are from Phil’s White Christmas virtual portfolio. One is to buy the SCO November $45/48 bull call spread, currently at $1.10. SCO ($44.94) is the ProShares UltraShort Crude Oil ETF which corresponds to 200% of the inverse of the daily performance of the Dow Jones-UPS Crude Oil Sub-Index. The premise behind this trade idea is that the price of oil has gone up a too quickly and is due for a pullback. Other ideas from the WCP are as follows (note: many bullish trades that worked were taken off the table, leaving those that didn't work - the bearish trades):

  • DXD ($15.91): Buy Nov $16/17 bull call spread at $0.50, now at $0.30.
  • DECK ($117.66): Sell Nov $105 calls at $7.50, now at $14.
  • SCO ($44.94): Sell Nov $42 puts for $1.60, now at $1.55.
  • DIA ($122.04): Buy Nov $119 puts at $1.52, now $1.38.

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