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Kabuki Theater Economy

Stock-Markets / Financial Markets 2011 Sep 19, 2011 - 03:05 AM GMT

By: PhilStockWorld

Stock-Markets


Best Financial Markets Analysis ArticleThe stock market was driven by three major influences this week: the ongoing European “Black Debt” saga, the Dollar, and rumors galore. The rumor that lifted the markets out of their initial funk on Monday was that China would be buying Italian debt.

Discussing the double-edge sword of Chinese investments, Chinese Briefing reported, “Debt-ridden European countries are longing for China’s purchase of their public debt despite fears that the country has motivations of a ‘reverse colonization’ of Europe. Nowadays the message ‘the Chinese are coming’ can often help governments trapped in financial crisis press public refinancing needs and shore up creditworthiness.


“As for China, it is reported that the country – whose US$3.2 trillion in foreign exchange reserves still have a heavy reliance on the U.S. dollar – is seeking more diversification and is increasing its holdings of the Euro.” (Concerns Grow over China’s Presence in Europe) The notion that white knight China was riding to the rescue of Italy fizzled out on Tuesday, when it turned out the rumor was based upon preliminary discussions that were unlikely to pan out.

On Wednesday, U.S. Treasury Secretary Tim Geithner asserted, “There is no chance that the major countries of Europe will let their institutions be at risk in the eyes of the market.” (Yet the Greek government one-year bonds are yielding over 110%.) Geithner pointed out that German Chancellor Angela Merkel has publicly stated “We are not going to have a Lehman Brothers,” referring to Lehman’s notorious implosion that exacerbated the financial crisis of 2008. (Geithner: Europe will not be a ‘Lehman Brothers’)

After a three-way conference between Chancellor Merkel, French President Nicholas Sarkozy and Greek Prime Minister George Papandreou on Thursday, Mrs. Merkel’s spokesman proclaimed: “German Chancellor Angela Merkel and French President Nicolas Sarkozy are convinced that Greece's future is within the euro zone.” (Merkel, Sarkozy: Greece Belongs in Currency Bloc) Also on Thursday, the Governing Council of the European Central Bank (ECB) announced its decision, “in coordination with the Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank, to conduct three US dollar liquidity-providing operations with a maturity of approximately three months covering the end of the year. These operations will be conducted in addition to the ongoing weekly seven-day operations announced on 10 May 2010.”

Are these operations “in addition to ongoing weekly seven-day operations” announced in May? Karl Denninger, The Market Ticker, thought not. He wrote:...“Wait a second...this isn't actually new! Remember, The Fed previously (like more than a year ago) announced these swap lines and more-recently announced their extension. So not only is this not new, it's not news!

“But the market is up big on the non-news news. Why? Because it appears banks are still going to be able to lie about asset values - for a little while longer.” (Oh Look! More Accounting Fraud!)

John Mauldin had another take. He wrote, “The Fed is not lending to European banks or even to the various national central banks. Its customer is the ECB, which will deposit euros with the Fed to get access to dollars. Making the safe assumption that the Fed knows how to hedge currency risk (fairly easy), the only risk is if the ECB and the euro somehow ceased to exist. And these are swap lines. This is not a new concept; it has been authorized since May, 2010. The real difference is that previously it has been used only for loans with 7-day maturity, and now that is extended to 3 months. This gives the ECB the ability to lend dollars for 3 months, which they must think will entice US money-market funds back into at least short-term commercial paper. (Just stay one step ahead of the ECB and the Fed, and your loan is “safe.” We will see how enticing this is.)

“Now, this is not without costs. It is effectively another round of QE, although theoretically less permanent than the last rounds, as the swap lines have a finite and rather short-term end.” (Twist and Shout?)

According to Bloomberg, “The premium European banks pay to borrow in dollars through the swaps markets decreased after the ECB lending announcement... ‘It’s an attempt by the central banks to make sure there’s enough liquidity so the markets don’t freeze,’ said Carl Forcheski, a director on the corporate currency sales desk at Societe Generale SA in New York.

Thus, the world’s largest banks rang the liquidity bell, jointly ensuring that EU banks would have access to as many Dollars as needed. This was well-received by the stock market. In response, the Dollar traded lower, and that popped the markets as the inverse relationship between the Dollar and the Dow remained strong most of this week.

Not everyone was persuaded that the actions of the EU powers will save the day. Peter Tchir of TF Market Advisors wrote, “Nothing that has been said or done this week goes against the view that Europe is preparing for Greece to default... After yesterdays conference call they said that Greece would remain in the Euro. They never said Greece wouldn’t default. That conference call was as likely to be scripting out the roles for the next few weeks to control the default and arrange post default financing for Greece. The language was not that strong and I don’t believe their words were chosen by accident.

“If Greece defaults the first obvious panic will be how do the European banks get funding, especially in dollars. Well, that question has been answered. The mechanism to avert short term liquidity problems after Greece defaults is now in place...

“They are going to let Greece default, try and contain the aftermath, and then get focused on some other serious issues.” (Policy Makers May Just Be Positioning for a Greek Default)

Similarly, Jamie Robertson, a Presenter at BBC World News, claimed “There may be a few people who still believe Greece will not default on its debt, but my suspicion is most of them also believe elephants can fly and the woods are populated by pixies.”

Jeff Cox at Marketwatch commented on the curious euphoria being demonstrated by the markets. “Despite a long-term picture in Europe that appears to be as unsettled as ever, investors will take any bit of good news and run with it. That’s been the message from a succession of trading days in which even the whisper of resolution the European sovereign debt problem - a conference call among policy makers, another bailout installment for Greece - sees the market go higher.” (Are Investors Taking Debt Crisis in Europe Too Lightly?)

Yves Smith of Naked Capitalism also expressed disbelief at the response of the markets to the continuing drama being played out: “Watching reenactments of scenes from the global financial crisis is a very peculiar experience indeed. The opening by the Fed of currency swap lines to allow the ECB and other central banks to extend dollar funding to Eurobanks was seen as an extreme measure the first time around, a sign of how close to the abyss the financial system had come. This time, allegedly because the powers that be acted before things got quite so dire, bank stocks rallied impressively.

Similarly, the media treated this move as just another episode in the ongoing Perils of Pauline drama running on the other side of the Atlantic... Now narrowly, the jaundiced media response and the market bounce both make sense. The Eurodrama has gone so many chapters that it’s easy to get rescue fatigue.” (The Fed Bails Out Eurobanks Yet Again)

David Fry observed “I couldn’t say how many ‘fixes’ we’ve had over the past two years, but there have been plenty. Each has proven ephemeral, but each new effort has become more assertive. This current plan now comes with wide global support. We have to remember these governments have skin in the game for their own economies. BRIC countries have plenty of ‘stuff’ to export to a healthy euro zone so they’ll be supportive. Bernanke is also determined to be a player rumored to be adding $100 billion in aid to Europeans. Also in support were the ECB, the SNB, the BOJ and the BOE. I guess you could say; ‘it takes a village,’ eh?

“They may be just buying time since the European populace is addicted to big government programs and benefits. What will happen if EU countries in trouble don’t play ball? Many will oppose austerity demands with violence if necessary making things impossible for politicians. Expect more troubles down the road.” (Hooked On European Bailouts)

The result, for now, is that Greece’s dreaded appointment with the Ghost of Default Future has been postponed. The cycle of austerity, protests, bondholder angst, and threats of default, followed by another round of bailouts, continues. It’s becoming the perverse status quo, an endless Kabuki theater of creditors and debtors with the same players coming and going, saying the same lines over and over. On the bright side of this mess, the fairly predictable sequence of events: panic, followed by bailout, followed by euphoria, followed by panic, creates a fertile environment to make profitable trades.

But the question remains whether anything has really been resolved by these actions besides the usual can-kicking. We are confident that the bandaid-like measures being announced this week will do little to stop the infectious spread of fiscal contagion.

Of course, Europe is not alone in its economic woes. The U.S. also struggling with a weak economy, notable for a stubbornly high unemployment rate, low workforce participation, a growing number of people who have been unemployed for a very long time, and record numbers of people needing food stamps. Other manifestations of a bad economy include the newly favored pastime of Dumpster Diving (for food), according to Michael Snyder. This week’s grim report on the number of U.S. citizens currently living in poverty will certainly weigh heavily on the minds of Fed members at next week’s FOMC meeting. Expectations are running high that the Fed will do something to help stimulate the economy. The outcome, which remains to be seen, will very likely move the stock market significantly, one way or the other.

Discussing the possibilities, David Rosenberg wrote, “The consensus view that the Fed is going to stop at 'Operation Twist' may be in for a surprise. It may end up doing much, much more. And this may be one of the reasons why the stock market is starting to rally (a classic 50%+ retracement, which always occur after the first 20% down-leg in a cyclical bear market would imply a test of 1,250 on the S&P 500 at the very least). Hedge funds do not want to be short ahead of next week's FOMC meeting, and who can blame them?”

What might the Fed do? David suggested several options, including simply buying more bonds (QE3) eliminating interest paid to commercial banks (to spur lending) or even purchasing foreign securities (killing two birds with one stone by supporting Europe while weakening the Dollar). “It seems that Bernanke, if he wants the market to rally, is going to have to come out with a surprise next Wednesday. If he doesn't, then expect a big selloff.” (Forget Operation Twist: Rosenberg Says Bernanke Will Shock Everyone With What Is About To Come)

We head into the coming week “cashy” and cautious, neutral to slightly bullish. All eyes will be on the upcoming FOMC meeting and announcement on Wednesday, September 21.

We have several option trade ideas for the coming week, two shorts (GMCR and oil) and two longs (PLX and SONC). These plays can be revised using stock strategies rather than option strategies, for those so inclined. See the inset boxes on this page (for the full newsletter, sign up for a free trial here).  Have a great week!

Phil

www.philstockworld.com

Philip R. Davis is a founder of Phil's Stock World (www.philstockworld.com), a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders. Mr. Davis is a serial entrepreneur, having founded software company Accu-Title, a real estate title insurance software solution, and is also the President of the Delphi Consulting Corp., an M&A consulting firm that helps large and small companies obtain funding and close deals. He was also the founder of Accu-Search, a property data corporation that was sold to DataTrace in 2004 and Personality Plus, a precursor to eHarmony.com. Phil was a former editor of a UMass/Amherst humor magazine and it shows in his writing -- which is filled with colorful commentary along with very specific ideas on stock option purchases (Phil rarely holds actual stocks). Visit: Phil's Stock World (www.philstockworld.com)

© 2011 Copyright  PhilStockWorld - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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