High frequency trading hedge funds were the stars of the volatility fireworks in this past week. The sheer explosion of volumes, the price action and the relentless rumour-mongering in a traditionally slow trading period are a trademark of this bunch. The resulting short-term ban on short selling introduced by France, Italy, Spain and Belgium may mean that they have lost this battle, but certainly not the war.
The aim of the rumour-mongering was clear: take a shot at the next domino in the European construct by putting the stocks of French banks under pressure through the sovereign downgrade rumours (French banks would get downgraded if their sovereign did). Taking aim at individual banks, namely Societe Generale, hedge funds tried to force a potential rescue by the French government, in which case the country could get downgraded anyway. In turn, this would probably force the collapse of the EFSF structure, since it is heavily dependent on the AAA rating of the second-biggest economy in Europe.
In this particular case, the short selling ban was therefore somewhat justified, since a major French bank going under would only happen as a self-fulfilling prophecy. Indeed, all French banks have a large deposit base. Hence the “Northern Rock” or “US Investment Banks” model does not apply here. Furthermore, the ECB would fill any necessary short-term funding gap in whatever currency. Hence any argument for the collapse of a major French name at least due to a short-term funding issue just does not add up.
Still, short sellers would not be involved in the European situation if the structural problems did not justify it. The pressure put on European governments by financial markets to act may not be enough. The Greeks are indeed eerily quiet, the Dutch just won’t shut up and the Germans are balking at increasing their exposure to the Old Continent’s debacle. Any structural reform at the European level (think fiscal consolidation) would take months if not years to be negotiated and implemented.
If that was not enough, a potential slowdown of the global economy would make the mathematics of budget balances only look worse, even if deep cuts are implemented (which would decrease growth anyway!). Hence, more than ever, the European Union has painted itself in a tiny corner, trying to fight the wolves with short-term actions via the only flexible entity around, namely the ECB.
The trump card for this quicksand scenario is whether the U.S. economy is simply experiencing a slowdown rather than an outright double dip. The judge is still out there although the odds seem to be slowly turning against this rosy perspective. One thing is for sure, bond markets are not pricing a deflation scenario in the U.S., as shown in the chart below:
Fed’s 5-year Forward Breakeven Inflation Rate – source Bloomberg
Although this inflation guage has fallen quite steeply this week, we are still far from a deflation scenario. Still this makes the upcoming U.S. CPI reading one of the most important reports next week.
In Europe, the agenda will remain driven by unpredictable political announcements and some may happen no later than the coming weekend. More short bans and other policy responses could well be announced before the Monday Asian market open.
Looking at indices in the short term, volatility is set to remain high. Our observation is that the type of corrections we have seen recently generally come in the form of an ABC wave. Hence, we would look at retracement levels to fade the rally underway. Still we would not go into the weekend short for the reason just mentioned.
An overcrowded trade before the sell-off, the DAX index created a line in the sand at the 5,500 level. In the current rebound, 6,000-6,100 should be a major hurdle before the downtrend can be broken. Should the 6,100 level be held or broken on announcements over the weekend, then we expect the rebound to extend to the Fukujima disaster lows or about 50% retracement of the latest sell-off (6,400 to 6,500 area).
DAX Index – daily chart – source Bloomberg
Then, it may be wise to cover your longs as we get closer to September since it is historically a bad month for stocks (sic!). In this respect, net short positions around the 6,500-mark should offer some reasonable odds of success.
For the S&P 500, the same reasoning applies: 1,180 – 1,200 looks to be a major hurdle and a break of the level should fuel the rally towards the 1,240 to 1,250 area. The line in the sand on the index for the downside comes at 1,100.
Strategically, we look for sound individual stocks that get punished due to earning misses as the over-reaction in nervous markets may create longer term opportunities. In the emerging markets space, we look to Brazil as a market that provides long-term opportunity since it is trading at a large discount to Asia and close to Russia on several metrics, whilst providing outstanding long-term fundamentals.
If you have the urge to get involved in short-term trading next week, small positions sizes and wide stops will remain the name of the game.
source from: tradingfloor
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