Don’t Believe the Hype

Why Yesterday's Stock Market Rally Is a Head Fake

In case you were out on a walkabout in the Outback and missed Wednesday's stock market action, the S&P 500 (SPX) had a massive 4.33% move upward. There were 3 causes of the move.

First, China cut its reserve ratio requirement by 50 basis points overnight, (which is the most effective means it has for trying to boost bank lending), which sent the markets up a bit over 1%. This is the first time since 2008 they have done so, indicating that the recent weakness in housing and construction markets in China is bad enough that officials acted aggressively today. But the part that should have investors worried is that the Chinese economy is hitting a wall despite massive amounts of bank lending (aka, deficit spending) equal to at least 37% of GDP in each of the last 3 years. Read this Wall Street Journal article for more details. The reserve cut is a sign of weakness. Buyer beware.

Second, there was coordinated global central bank action to lower swap rates for European banks borrowing dollars. Effectively, the Fed, ECB and other central banks are trying to make it attractive for banks in the Eurozone to borrow dollars directly from the ECB instead of in the private or interbank markets – this mainly has the effect of keeping LIBOR down a bit and possibly easing a liquidity crunch that was (appropriately) seeping into European markets. This was good for another 2% or so move in the markets. However, this does nothing to solve the underlying credit issues that are plaguing Europe, but merely postpones the day of reckoning a bit. For more information on how these Central Bank swap lines work, click here.

The third reason for the move was that the markets were oversold and trading on light volume (which makes the sustainability of the move suspect). Despite the big move on "news", the markets stopped dead in the middle of the resistance band of 1245/1250 on the SPX, which I noted in my recent post. From here, I expect a sideways consolidation in U.S. stocks for a day or two, probably followed by another leg down next week when the hype is replaced by reality. Why the long face? Read on.

More swap lines aren't going to change the reality of insolvent countries, which is the real issue that hasn't yet been addressed. In fact, I suspect Wednesday's Central Bank action was directly related to the pressure that European countries are putting on their own banks to buy their sovereign debt. That's right, the same governments that are telling them to raise large amounts of capital (via the European Banking Association new capital rules set to go into effect in June 2012) are also pressuring them to buy the debt of their own countries. And you thought U.S. lobbyists were bad? Read this Wall Street Journal article – it's eye-opening. So the banks that are being force-fed bonds are being given a little push by having their borrowing costs lowered a bit. However, when you are looking at 40%-50% "haircuts" (read: losses) on sovereign debt and the voiding of the credit insurance on that same debt, you could lend me 100% of the purchase amount at 0% interest and I still wouldn't touch that deal. 50 basis points on funding versus 40% losses on principal? No thanks, I can lose my money in Vegas and at least get a free drink and $3.99 buffet coupon.

So while the markets Wednesday liked the new swap lines and lower reserve requirements for Chinese banks, those actions are simply delaying the inevitable. The austerity programs that Germany wants strictly enforced will exacerbate the problem, as the affected economies shrink from less government spending and higher taxes. There are only 2 solutions: either the ECB becomes the buyer of last resort in unlimited amounts, or the Euro breaks up. Since Germany seems highly unlikely to support unlimited ECB buying, the Euro breakup becomes more likely, which will roil markets globally when it happens. If Germany changes its tune on ECB buying, then the stock markets will go screaming higher, as the real resolution will be at hand. So monitoring the German mood regarding the ECB will be the key to making the right call on the markets going forward. And right now the mood isn't good. US banks like Citigroup (C), Bank of America (BAC), JP Morgan (JPM), Goldman Sachs (GS) and Morgan Stanley (MS) will be the ones to buy on the selloff when the Euro break-up occurs, but not before…patience young Skywalker. Until then, enjoy the bounce, raise some cash, and play defense. It's best to heed the advice of Public Enemy and "Don't Believe the Hype".

Support and Resistance levels for the S&P 500 (SPX) are:

Support: 1235/1238, then 1228/1230 followed by 1218/1222. Below that its 1198/1202.

Resistance: 1246/1250 has a lot of resistance, with a little at 1255 and a big level at 1264/1266.