The market isn't going straight down. While the S&P 500 and its tracking exchange traded fund, SPY (SPY), has rallied nearly 20% from the summer lows of last year, and stocks such as Apple (AAPL) are up nearly 30% in the last year, the last several months have been brutal.
Indeed, while the S&P 500 has sold-off around 10% in the last several months, market leaders in sectors such as energy, the industrials, and the financial sector, have sold-off hard. Market leaders such as GE (GE), Citigroup (C), JP Morgan (JPM), and Exxon-Mobil (XOM), have also performed poorly.
(charts courtesy of thestreet.com)
Still, despite the recent disappointing job reports in the U.S., and poor economic data in Europe and and China, the recent bailout of Spain and Fed commentary about possible new stimulus measures has helped the market rally for two straight weeks.
The first reason I think the market will rally next week is the Greek elections are unlikely to produce a government that would withdraw from the eurozone. With over 70% of Greek debt held by foreign banks, and German and French banks the largest holder of Greece's bonds, Germany and France are unlikely to accept repayment in Drachmas. Greece is dependent on the EU and IMF for emergency funding, and the Greek government will likely need to comply with EU and IMF demands to receive additional funding. Polls also show 8 out of 10 Greeks want to stay in the EU, and even the leftist leaders in Greece have said that their party has no plans to withdraw from the EU.
The second reason I think the market will continue to rally next week is a likely short-term peak in fear levels. While there have been a number of reports of massive withdrawals from the Greek banking system over the last several weeks, the Greek government is still dependent on the EU and IMF for financing. The recent bailout funds that Spain received are likely just one of several additional bailouts Spain and the other PIIGs will need.
Still, Germany has recently openly discussed increasing the European Financial Stability Fund significantly, and the EU and IMF remain committed to continuing provide funds to Greece as well. While Germany has been very resistant to calls for euro bonds, and new, more aggressive forms of monetary easing, Germany's recent comments suggest continued economic deterioration in the eurozone is making politicians more willing to take aggressive measures. The fact the recent Spanish bailout did not face significant political opposition in France and Germany, who are providing nearly half the funds, also suggests political opposition to bailing out the PIIGS is weakening.
Finally, the last reason the market will likely continue to rise next week is that bearish sentiment remains very high. While sentiment is always hard to gauge, put option volume in the S&P 500 has spiked enormously over the last month, and short positions in financial stocks such as Citigroup and Bank of America (BAC) have increased by over 50% since mid-May. While put options are obviously traditionally are bets on a continued sell-off, traders and investors also often hedge positions in the options market. With longs likely heavily hedged and the volatility premiums in put options having fallen significantly in the last couple weeks as the VIX has fallen nearly 20% from its highs this month.
To conclude, while the S&P 500 has held up reasonably well during the recent sell-off, cyclical stocks in sectors such as energy, the financials, and the industrials, have sold-off hard. European and Chinese stocks are also trading at one year lows. While the Fed may be limited in an election year, EU leaders are taking more aggressive actions to address the PIIGS financing problems, China and Europe are now openly considering delaying new more stringent financial regulations, and the U.S. economy remains unlikely to reenter a recession
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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