Weekend Roundup: The Standoff Continues but Sentiment Shifting

On option expiration Friday, the equity markets followed a pattern very similar to what seen on Thursday. The market challenged the 900 level on the SPX but was sold off hard even before it reached Thursday’s highs just below 900. The sell-off was brutal with the SPX falling almost 18 points from its intra-day highs before finding its feet.

However, the key technical levels around 875-880, corresponding to the 20 day SMA

The bears can take heart from the fact that for almost three days, the SPX was rejected at the 900 level. The bulls can take comfort from the fact that the 875-880 level has held during the same period.

Sentiment Shifting?

Of greater importance was the sentiment shift visible on Friday where better than expected consumer sentiment number and steady inflation numbers could not ignite a sustainable rally. The sell-off on Tuesday following the poorer retail sales number showed that the market is no longer ignoring bad news.

The inability of the market to rally on good news on Friday further confirmed that the current bullish run is showing signs of exhaustion.

The longer the market stays in this 875-900 range, the greater the likelihood of a more significant correction. During the past month better than expected earnings and economics news, and the relatively benign stress-test results provided the bulls with the ammunition to charge higher. Going forward the catalyst to drive the markets higher are likely to be harder to find.

I expect a downward bias, with the probability of a correction down to low 800s on the SPX increasing.

Global Events: Europe weakens but India Pleases

The bad news from Europe continues with the GDP contracting at a rate of 2.5% in the 16-member Euro region,

the highest ever since data was first compiled in 1995. Germany’s GDP fell 3.8% the largest drop since 1970 when the data compilation started, showing how even the strongest Euro-zone economy is getting weaker.

On the brighter side, elections in India led to a convincing win for the ruling Congress party, raising hope that economic reforms will accelerate as the pesky Communists are sidelined.

Expectations of growth from China and India are one of the pillars holding up global growth story, and the election result is a welcome sign. There are expectations that both the Indian Rupee, and the Indian stock markets will jump up to catch up with the rest of the emerging markets, now that the political uncertainty has been resolved in a positive manner; futures on the Indian stock market are up 11.25%. Some ETFs which US based investors can use to add exposure to India are EPI, PIN, and the INP.

Re-Assessing Treasury Bond Risk Across the Yield Curve

On Thursday, I had written that I planned to roll any in the money call option on my TLT holdings. However, the inflation data for April, released on Friday, showed that though prices declined, deflation risk is remote forced me to re-assess the risk associated with the long bond holdings.

A key metric I am following is that the spread between the 10 year treasury yield and the 30 year treasury yield has continued even during the February sell-off.

The spread hit a high right after the Fed’s Quantitative Easing announcement in March, and has continued to bounce of its 50 DMA since early 2009.

There are several underlying factors contributing to this wide spread. The focus of the Fed’s Quantitative easing policy is likely to be in the 10 year bond, since most long term consumer and industrial debt tends to be priced off this duration. The critical 30 year mortgages key off the 10 year treasury yields.

There is also the fear that the Quantitative Easing and high Treasury issuance is likely to put a pressure on the US Dollar over the long term. As a result longer term bonds are likely to price in a higher currency risk premium, especially when it comes to foreign buyers of bonds. In summary, bond investors are recovering from the panic of the past year, and recognizing the risk of locking the rate for 30 years.

The only likelihood I see of the 30 year yields pulling back sharply is a major economic shock, which forces the world markets to completely overhaul the prospects of global growth.

However, governments world-wide have signaled, with strong conviction, that they will not allow the failure of any institution of systemic importance. As a result, with each passing week,

the likelihood of such an event goes down.

Based on the above, I decided to allow a portion of my TLT position to be called-out by not rolling over the

call options I had written. I plan to exit the remaining positions gradually over the next few weeks, on any spike in risk aversion.

I feel that the shorter term bonds, which can be traded by using the IEF (7-10 yr) and the TLH (10-20yr) are relatively a safer bet, and more likely to benefit from any Fed action.

For bond investors, the junk bond (high-yield: JNK, HYG) and corporate bonds (investment grade: LQD) are also attractively priced relative to their long term spreads against treasuries. Assuming that the economic recovery story does not prove to be a complete illusion, the spreads are unlikely to widen in the same catastrophic manner as they did last fall. Though these bonds have rallied a long way from the depth they had fallen too, buying these bonds on bouts of risk aversion is likely to provide good long term gains.

My Portfolio: Trading Plan

I expect a bearish bias going into next week. Some of the sectors I am watching carefully are the commercial REITS (IYR), Energy and Precious Metals.

IYR has broken out of its channel and is likely to break the support level

of $30 it has been testing over the past few days.

Potential price targets are in the $28 and $26 level. I plan to take profits on my puts at these price levels.

Energy is likely to continue to pull back after its strong run, as the market re-assesses the green shoots. I am looking forward to establishing a long position in the Oil Services Holder (OIH) in the mid 80s, around the level of prior resistance which should prove to be a strong support level.

The other leg of the commodity reflation/weak dollar trade is precious metals. Precious metal and mining stocks have had a strong run, thanks to the weaker dollar during the bull-run.

It is likely that any strength in the dollar is likely to put a halt on this rally and lead to retracement.

I am hoping to establish long positions when the GDX reaches the $32-33 level, which is close to a supporting trend line stretching from early January. The $33 level corresponds to the 62% retracement of the rally from the March lows ($29.16) to the April highs ($39.55) Establishing a position near a trend line provides a good stop out level allowing you to cut losses on a trade.

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