Marketview: Playing With Fire

• Posted by DynamicHedge
• on March 23rd, 2013

 

The $SPX produced a gap open on 4 of 5 days this week. This alone should speak volumes about the level of uncertainty. Just when headline risk seems to have exited the market, another island nation banking crisis ensnares traders and investors. I blame page-view journalism.

Jobless claims and housing starts reported in-line with estimates. The FOMC rate decision was a non-event with an 11-1 vote to keep policy unchanged. The committee reiterated key signal metrics of 6.5% unemployment and 2.5% inflation. The driver of sentiment at the moment is Cyprus. Unfortunately, I couldn’t get this into a post during the week so I will share my thoughts now:

• German politicians are performing a high stakes tight rope act. Another opinion is that if the EU wants to make an example out of anyone, it should be Cyprus. Most have already conceded that laundered money makes up the majority of its large deposit base. Plus, of all the countries in the EU at risk to default, Cypress is the least likely to cause contagion. May as well play hardball. The problem is that Germany is in a recession but still has relatively low unemployment and wants to keep it that way. Placing higher burdens than current austerity measures on periphery countries could signal that dealing with the EU is no longer worth it. Inflicting too much damage to the other EU economies also means less capital to buy German exports. If German exports fall, the unemployment rate will rise and set off dramatic political change. German leadership want to show they are tough (and not to be messed with) without crippling the economies around them.
• Russia cannot be counted on as a default backstop. The Russians have helped Cyprus in the past but have now signalled that the risk/reward has changed, and they’re pulling support. Maybe an out-of-favor oligarch has a couple billion stashed in Cyprus and Putin has a score to settle. Who knows? Don’t count on the Russians — if for no other reason than they understand the value of waiting.
• Precedence matters (duh!). There is an argument that Cyprus is simply too small to matter. One tired anecdote is to compare Cyprus to an equally sized US State and say, “See! You wouldn’t care about Rhode Island, so why would you care about Cyprus?” This is of course absurd because we’re talking about precedent. Think of it another way. If any US administration ordered a drone strike on a US citizen on home soil, surely people would not focus on the victim’s life relative to the total population, but the overall policy shift the action represents. It is the reaction to the event that is difficult to predict.

The last couple years have been about maintaining status quo. The reaction to the situation in Cyprus is entirely unknowable, and there is likely no optimal solution. Anyone that tells you different is lying. The best strategy is to trim up some longs and hope that the Cyprus crisis has a similar consequence-to-headline ratio as previous Euro-scares.

NOTE: As a I write this, there is a report of a more progressive solution of 4% levy on deposits over $100k and 20% levy on deposits over $100k held at the Bank of Cyprus.

From a technical perspective, no one can argue that the market isn’t holding up well in the face of terrible news. The long-term trend remains in-tact. However, we are late in this run.  For the last couple weeks, my core message has been to step up discipline and manage positions defensively, even though our indicators are still skewed bullish. Nothing has changed. Long discipline, short near-term predictability.

Although the market was little changed, there was a healthy disagreement between buyers and sellers which resolved in a decidedly risk off rotation. Consumer staples, healthcare, and utilities were winners. Lagging sectors were basic materials, financials, and energy. I’m watching utilities closely as they move from underperformer to outperformer.

Winners: $NKE, $EBAY, $AAPL, $COST, $TGT, $WAG, $CVS, $HON

Losers: $HAL, $SLB, $GS, $MS, $FDX, $LOW, $CSCO, $ORCL

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