EUphoria as Draghi Unveils "Big Bazooka"

September 9^th, 2012

Nick Hays

Dhaka, Bangladesh

Today – on The Long and the Short

* Stocks jump as ECB announces major policy shift, warms up the printing press

* Economic picture worsens – global manufacturing now in contraction

* Liquidity versus fundamentals - central banks and the law of diminishing returns

After a muted response to Bernanke and the Fed at Jackson Hole, it was the turn of another central banker to give the markets a massive boost on Thursday as “Super” Mario Draghi announced that the ECB stands ready to purchase “unlimited” quantities of Eurozone sovereign bonds, subject to certain qualifications.

Though the move was widely telegraphed ahead of time, markets reacted strongly to the announcement with major European stock indeces rallying 2-3% and the European banks jumping 5%. Gold rallied 2.4% and the Euro gained 1.7% against the Dollar the following day.

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The ECB, under pressure from German politicians and the Bundesbank in particular, has to date shyed away from direct purchases of sovereign debt, fearing this would undermine deficit-reduction commitments and stoke inflationary pressures.

Thursday’s announcement therefore marks a major change in ECB policy, essentially providing a ‘safety net’ for sovereign debt yields by paving the way for the central bank to directly purchase government bonds with newly printed Euros.

Meanwhile, the macroeconomic picture worsened with the August PMI showing that the manufacturing sector in almost every major economy is now in contraction. In addition it was announced that the US economy managed to create just 96,000 jobs in August, significantly missing the market expectations of 130,000 and fuelling concerns that the US is not growing enough to significantly reduce the unemployment rate.

Amidst this dismal backdrop, the strength of the market reaction to the ECB policy shift suggests that this may have been the “big bazooka” policy response that markets were hoping for.

However it remains to be seen how long the afterglow will last this time; previous periods of market “EUphoria” have turned invariably to disappointment as details of the latest ‘cure’ are picked over and flaws exposed.

In deed the longer-term risks of this latest plan cannot be ignored. In particular the potential inflationary impact of “unlimited” money printing; the potential loss of the ECB’s political independence as it strays into territory that looks dangerously like entangling itself in government fiscal policy; and the possible dampening effect the monetary back-stop will have on deficit-reduction efforts.

The EUphoria “half-life” in this case may be days, weeks, months or even years. What seems certain however is that even central bankers are not immune to the law of diminishing returns and eventually the marginal effectiveness of monetary policy will reach its natural conclusion.

When this happens we will realise that the floor we are walking on is thin ice.

Liquidity can trump economic fundamentals for only so long: eventually, something has to give.

Despite this, the adage “bad news is good news” continues to hold true for equity markets. Central banks are still pulling the strings for now and are largely succeeding in inflating asset prices in developed markets. The momentum behind the current bull run tells me it has legs yet and for the timebeing it pays not to stand in its way.

Sentiment can change rapidly however, and I recommend long positions in equities for short-term speculation and ultra-long-term investors only.

Trading update coming soon, where I plan to point out some big moves in Gold and the Dollar, as well as the latest on my S&P 500 trading.

Meltdown or “Melt-up”? Markets Await Fed Chairman Speech at Jackson Hole

August 28^th, 2012

Nick Hays

Dhaka, Bangladesh

Today – on The Long and the Short

* S&P 500 meets short-term resistance (as forecast)

* Mild correction on weak volume as markets await key Fed speech at Jackson Hole (Aug 31)

* VIX spikes 20% after hitting 5-year low

As forecast in my last post, the S&P 500 encountered resistance at the 1420 level and is correcting (mildly so far) from a short-term overbought position. As well as being a technical sell-off this is also being driven by profit-taking ahead of Ben Bernanke’s speech at Jackson Hole on August 31^st.

Bernanke’s speech is expected to provide the markets with more clues as to the direction of Fed policy (QE3 – will they or won’t they?) and with the performance of risk assets increasingly tied to expectations of monetary stimulus, Friday is setting itself up to be a critical day for the markets.

Messages coming out of the Fed ahead of the 31^st have been distinctly mixed and the potential outcomes are looking increasingly binary in nature – meltdown or “melt-up”? Amidst this uncertainty, we are seeing some profit taking place and the drop in volume suggests many traders have moved to the sidelines.

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This increased uncertainty can also be seen in the so-called 'fear index'. Since my last post, where I pointed out that the VIX’s 5-year low was signalling an overly-complacent market, the index has jumped more than 20%:

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As hoped for, soon after I last wrote, a shorting opportunity presented itself: a brief ‘head-and-shoulders’ rally above 1420 failed and consequently threw up a decent opening for a bet on falling prices at the 1419 level. See chart below:

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Since the short at 1419 the market fell as much as 1.5% intraday on the 24^th, then recovering some of that ground. As shown above, secondary resistance may now be forming at 1415.

Now that I am short the market, do I need to review my original stops to manage the risk/reward? Considering the unpredictable and potentially high impact newsflow coming up on the 31^st, this is a critical question.

A stop-loss too close to 1420 and I may be taken out too soon by another ‘head-fake’ like the one we saw on Tuesday; too far out and I leave myself open to the risk of greater losses.

Given the environment, my current stop-loss of 1440 is too far out I feel so I am going to reduce risk by moving the stop-loss a little closer, to 1430. This should be enough to catch a 'genuine' breakout above 1420 at which point I can cut my losses.

On the downside, I see a decent chance for short-term gains in the coming week. Should Bernanke disappoint, either by hinting at no further stimulus or simply by offering very little in terms of new information, we may see a stronger sell-off.

For the timebeing I am maintaining the original target of 1370 - this is at the lower end of the upwards trading channel where the market may find some support.

We'll keep watching to see what the next few days bring. No doubt Friday's speech by Bernanke will be closely watched and should provide some direction to the markets, one way or the other.

Shorting opportunity

August 17^th, 2012

Nick Hays

Norfolk, England

Today – on The Long and the Short

* Short-term correction possible

* S&P 500 approaching resistance levels at 2-year high

* Market complacent? VIX at 5-year low

The S&P 500 is approaching some critical price levels and a number of indicators are pointing to a short-term correction.

Firstly however, a look at the medium-term picture. As I wrote in my last post, hopes of further monetary easing by the Fed and ECB promises to “do whatever it takes” appear to be trumping the poor economic data for now, and this is translating to higher equity prices.

The S&P 500 index has broken above its 200 and 50-day moving averages in what looks like a fairly convincing manner and both averages appear to be providing some level of support. See the below chart.

In the shorter-term, however, a correction looks quite likely for three main reasons.

First, the index is approaching 1420, an area which twice provided resistance back in March (shown in the chart below). This resistance level is the index's highest for more than four years (since May 2008) and so represents a significant test of the conviction of this current bull run.

Second, the index is close to the upper range of the bullish channel which has formed since around June. This should also provide resistance to a further rise in the short-term.

Third, the RSI, while in an uptrend since June, has been looking toppy at 80+ and the last few days may be already signalling some loss of momentum.

I see an additional reason for short-term caution in the VIX. The so-called ‘fear index’ is now at a 5-year low and well below its long-term average. This could be signalling some complacency in the market.

With the S&P flirting with the critical 1420 level, watch carefully for a shorting opportunity next week. Target of 1370 and a stop-loss at 1440 should resistance levels be taken out.