Guest Post: Whack-A-Mole

From Peter Tchir of TF Market Advisors

Since last Thursday, the government bailout rally trade has been on.  Last Thursday, the EU announced a new round of bailouts for themselves.  That sparked a rally, it also sparked lots of talk about S&P 1,400.  Lots of people I spoke to, were talking about the parallels to the end of June where stocks shot up 5% in the last week of trading.  The catalyst for the next move higher was 'obvious' to everyone, the debt ceiling limit would be raised and stocks would be off to the races.  Since then, every time the longs have popped up their heads, the market has found a reason to smack them down.

The European rally barely lasted 24 hours.  On Thursday SOVX gapped 35 bps tighter.  Friday morning, it had moved another 35 tighter, only to close unchanged on the day.  It is now only about 20 bps tighter than where it closed last Wednesday.  In the real world, Italian and Spanish bonds are back under pressure and close to their pre bailout level.  Maybe the bailout would work if the IIF had actually released any real details by now.  Maybe some details on what EFSF would actually do or could really hope to accomplish would also have helped, but the only thing that has come out on the EFSF is that some EU members, and finance ministers, are nervous about creating a piggy bank for the PIIGS.

In spite of some weakness in stocks on Monday and Tuesday, it was clear that investors were still betting on a relief rally from the debt ceiling crisis being resolved.  No one seemed to really believe that it wouldn't be resolved, and actually were happy to see markets weaker as it gave them a buying opportunity.  By Wednesday it was clear that everyone was either long or less short than they would like, but were still reluctant to do much about it because they just knew that Washington would come to the rescue.

Washington will ultimately come to some form of 'compromise' on the debt ceiling.  Just like last year when we kept the Bush tax cuts and created some new payroll tax cuts, the rest of the world will be left scratching their heads wondering how Washington defines compromise.  Will we still get the relief rally? 

That is the question we need to figure out now.  Any hype about whether or not we will get a solution is just hype.  Their will be a solution, but it will do nothing to appease the rating agencies, and more and more, will it do much to appease investors?  The European situation is clearly deteriorating again.  The realization that the headlines sounded good, but the actual benefits were less clear when analyzed closely, and that the plan is not easy to implement, is weighing on Europe.  The economic data, here, and in Europe has been mediocre, so that will make it harder to get a big spike in stocks after any solution.

Bernanke and the Fed have to re-evaluate the grade they gave to QE2.  How we have such a massive revision in Q1 GDP is hard for me to understand.  Seriously, we need to find a way to get better data, but with a 0.4% quarter right in the heart of QE2, it is clear it did nothing to help the real economy. And yes, it is getting old, but I will say it again, the market is not the economy.

I am now cutting all my short.  I had cut some coming into this week, as I was scared of the rally, but kept enough on that I can't complain too much.  I am flat and tempted to go long.  We've had a big move, and government resolution is likely to come, but it feels like that is a crowded trade.  No one seems really afraid, and everyone seems to expect a bounce.  Just because everyone expects it, doesn't make it wrong, but I'm concerned that all the longs will pop out of their holes the second a deal is announced.  They will look around for someone to panic and take them out of their positions on the debt ceiling news.  Then they will look some more, and then realize that no one is caught short or surprised and they will scurry to get out of their positions.  Well, I just convinced myself to go back to putting on a small short.