World Equity Markets Slump, And We Are the Flight to Quality??

by Dan July 12, 2011 8:39 am • Commentary

My whole premise for being short and bearish all spring and skeptical of the rally off of the June lows was that global markets under-appreciate what appear to me to be a rapidly increasing list of potential issues that severely threaten the pace of our recovery, and could possibly send us back into recession……U.S. markets and the DAX are 2 of the only markets up year to date around the entire globe!!  What does that tell you? There is a massive flight to quality….in U.S. equity markets…..really??  

Global markets were down a lot of overnight with the Nikkei and Shanghai Comp closing down ~1.5%, European Markets are down about 1.5% as I write and our futures are down about 1/2% (well off their lows of the morning).  The world fears a “European Debt Contagion” and rightfully so as it appears there are a whole host of countries that are just waiting to default.

As an investor/trader, it appears the list of risks to stable markets and a growing world economy continue to grow…..some of these issues have short term solutions, and beware of the sort of headlines that we got a few weeks ago like”Greek Crisis Averted”…..because if we have learned anything from the situation in Euro-land, there will always be another “pig on the wing”.

Here is a quick little list of what many believe to be the pressing issues of the time, and in my view, the resolution or lack thereof, will determine whether our equity markets close up or down on the year.

1. European Sovereign Debt Crisis

2. Health of U.S. recovery, which has clearly been called into question by Friday’s jobs data.

3. U.S. law makers ability to craft a deal in the next few weeks to raise the debt ceiling and avoid “default”.

4. Emerging markets’ ability to drive demand while also cooling inflation and orchestrating a soft landing for their rapid growth.

5. Rising prices of food and energy not only crimping consumers but hurting corporate profitability.

As it relates to this list we are very likely to get some tape bombs, both positive and negative that will keep things volatile…..we will have plenty of rumors about downgrades of Italian and Spanish debt, then rumors of aid packages and intervention and then a list of votes much like we saw with Greece…..

The U.S. debt thingy will be the gift the keeps on giving for cable news and will probably come down to the wire….this is one where the markets may need to be the one to intervene and cause politicians to come to their senses and strike a deal everyone can live with….A break of mid June lows in the equity markets and down on the year may just do the trick as few politicians will want to be up for re-election in the coming year with the backdrop of an economic environment anywhere resembling that of 2008, where anyone deemed to be complicit or ineffective about the then crisis was summarily thrown out of office.

The health of the U.S. recovery is a dicey one and there wont be any clear answers on this one……corporate earnings and guidance, much of which we should get over the next few weeks and will likely be the driver of our markets…..If the outlook is better than expected we could see a flight to quality……but if we get reports that look a lot like AA’s last night (only meeting already lowered estimates) than we could clearly see markets down on the year this summer.

As for emerging markets, we will continue to see a focus on China’s data as it relates to inflation and the strength of their economy and this will cause volatility in commodities…..but much more difficult to play….

It also appears that at any point the issues in the Middle East and North Africa could rear their ugly heads again as the situation in places like Syria seems to be deteriorating…….a pro-govt mob even attacked our embassy yesterday……hmm…say hello to our friends at Seal Team Six.

MY TAKE ON THE MARKETS:  The SPX will try to hold 1300 and a failure sends us right back to looking at similar levels from June….but the only one in my mind that will really matter will be the previous low of about  1265. That is a ways away, but as we take-out technical levels below 1300 you could see some acceleration in selling of stocks that showed massive outperformance in the rally……watch names like AMZN, WYNN and CMG, if they start to come undone than watch out below……

Also of great importance will be how banks stocks react to whatever dismal news they are about to report….JPM and Citi report this week and while expectations certainly are not high, a negative reaction that sends them to new lows would be particularly bearish for the overall market, even-though they have underperformed all year.

This sell off caught me a little off guard as I wanted to lay out some more shorts, but was waiting for a blow off top to new highs….I will look to do so on the next move higher…..I am not of the belief that U.S. companies are going to stick their necks out in this sort of environment and offer over aggressive guidance….visibility into their business must suck and with most stocks up on the year, they might as well be conservative given the list of risks above.

As always continue to move your feet take profits when you have them on a portion of your positions as I did yesterday in Citi and FXE….and cut losses as I suggested, buying back the short put in the BAC Nov risk reversal. When markets make big moves in one direction like the one of a few weeks ago, look to buy in wings of positions that have gone against you as CC wrote June 30, taking in a short line for next to nothing that looks like it will never see action again, only to have the market reverse hard.  In markets like this I like using options on directional views to define my risk, but also in an effort to not over trade…..