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Thursday, March 28, 2024

2,050 or Bust – Can the S&P 500 Avoid a 4th Weekly Decline?

SPX WEEKLY10 points.  

That's what we need on the S&P today to reverse what is turning into a very ugly downtrend on the weekly chart.  We've been discussing that line since February as the danger zone and, if you read us at all, you KNOW we short the S&P every time it gets to 2,100 and the last visit was mid-April, when I warned it wouldn't last in "Toppy Tuesday – What More Can They Do?"  At the time, the market had spiked up on enthusiasm over the "emergency meeting" between the White House and the Fed – nothing came of it and the markets promptly began to fall for the next 4 weeks.

In that article, I noted that we expected weak earnings, especially in the Financial Sector and, more importantly and more relevant to today's discussion, I warned that the real crisis was China's growing debt load, saying:

As money is sucked out of the pockets of the many and placed in the bank accounts of the few, China's economy (like ours) has stagnated as consumers can't afford to buy the goods they are producing at work and, as of last year, Chinese firms had only just enough operating profit to cover the interest expenses on their debt 2 times, down from 6 times in 2010.  That means a rise in rates OR a decline in profits can quickly lead to a huge economic crisis with massive defaults. 

As credit stresses mount, China is drafting rules to make it easier for lenders to convert bank loans into equity stakes of debtor companies. China may also approve, as soon as this month, a plan allowing banks to convert as much as 1Tn Yuan ($150Bn) of soured debt into equity – a very bad idea.

Last May (in case you forgot) is when China began going off the rails – triggered by a wave of defaults that I was warning you about all spring.  The problem was, I was too early with my warnings and a lot of people got complacent by May so this year I've waited before bringing it up again but the cycle will begin again soon and we need to keep our ears open for reports of Chinese loan defaults.  Our own market followed China down with a 20% drop in July.  

And, of course, Japan, Brazil, Greece, Italy, Argentina, Venezuela, Puerto Rico, Jamaica, Ukraine… have I mentioned how much I like CASH!!! lately? 

 These are just a few things to worry about before we start worrying about the still-likely Brexit and the repercussions on the Euro-zone.

After my April 15th article titled "TGIF – Stop the Rally, We Want to Cash Out!" it was so obvious to me the next week that I titled my April 19th post "Technical Tuesday – Short the Dow at 18,000! S&P 500 at 2,100!"  Dow (/YM) futures pay $5 per point, per contract so 17,450 is $2,750 gained and S&P contracts (/ES) pay $50 per point so 2,050 is $2,500 per contract gained on the S&P Futures.  In that same post we called a long on July Natural Gas Contracts (/NGN6) at $2.13 and they are $2.19 this morning for lovely $600 per contract gains but we've been in and out of those a dozen times since – playing the channel.

April 26th was "Tempting Tuesday – S&P 2,100 is Still the Line to Watch Ahead of the Fed" and that will bring us up to today as I set up yesterday's Trade Alert when we initiated this hedge:

If it all goes to Hell this evening, it will be Apple (AAPL)'s fault so it makes sense for us to add an Ultra-Short Nasdaq ETF (SQQQ) hedge that will pay us $15,000 in the STP, to offset some of the losses on the longs we haven't sold yet.  Given that our immediate concern is a poor report from AAPL (and if there is one, we'll be buying that dip!) we can take a short-term cover in our STP for earnings season:

  • Buy 40 June SQQQ $17 calls for $2 ($8,000) 
  • Sell 40 June SQQQ $21 calls for 0.85 ($3,400) 
  • Sell 5 AAPL 2018 $85 puts for $7 ($3,500) 

Consider how this hedge works.  If AAPL has bad earnings, the stock drops but probably not 20% (now $105) and the short puts would be safe while the Nasdaq falls with AAPL (it's over 10% of the Nasdaq) and SQQQ (now $18.45) will shoot higher and we should be $4 in the money, collecting $16,000 on our spread.

Of course, AAPL did indeed crash the market and, as you can see on the chart, SQQQ popped up to $20 but hasn't closed the deal at $21 so we're taking $3.50 ($14,000) and running on the calls, which is 87.5% of our maximum possible payout.  Earlier this week, we called a bottom on AAPL and pushed our long positions and yesterday, at 2:15, I called a bottom on the Nasdaq saying:

SQQQ (STP) – Let's sell the June $17 calls (20) at $3.50.  That will actually make us much more bullish but my intent is to cover with Sep calls if the Nas heads lower – June it too close for comfort. 

SQQQ – Same move as OOP, we'll cash in the June $17 calls.  Those are our closest hedge to expiration so we'll take the profits and, if the market goes lower, we'll re-establish with more-useful Sept calls and, if the market goes higher – we look like geniuses for cashing in here. 

And no, this is not an all-clear for the market.  In the Short-Term Portfolio we also have SDS and TZA hedges and, in the OOP, we have SDS, TZA, as well as another SQQQ hedge so we're just locking in some of our bearish gains in anticipation of at least a bounce off 4,290 on the Nasdaq Futures (/NQ), which is the -2.5% line from 4,400.  The 110-point drop means we're looking for a weak bounce of 22 points and a strong bounce of 44 points so 4,334 would be our target and, what do you know – there it is:

I wish I could tell you we're using World-class algorithms running on state of the art quantum computers and such to make these predictions but it's just our 5% Rule™ doing what it always does – telling us what's going to happen before it does – and it runs just fine on the free pop-up calculator in Windows or an abacus, for that matter.  

Speaking of Al Gore – boy is it hot in India (and Florida too, per my mom).  123.8 degrees in May is a brand-new record but a spokesman for the Koch brothers said "It's not the heat, it's the humidity" and maybe he's right and we should just ignore it but, unfortunately for Indians – monsoon season starts in two weeks – so they'll have both!  

Where was I?  Oh yes, China's unsustainable debt bomb.  That's what I was warning you about in April and, as I said at the time, I didn't want to jump the gun and panic too early but it's almost time to panic as Corporate Bond Defaults are rising at an alarming rate and that's making it difficult for Chinese companies to issue new bonds as April issuances went off a cliff (Feb is low due to holidays).  

As we move into the end of May, it looks like this month's fundraising will fall short of the $83.6Bn needed to roll over existing debt and that means LOOMING DEFAULTS by companies that have been unable to raise new capital fast enough to service the debt on the capital they already raised.  “Many Chinese companies are relying on new borrowings to repay their old debt,” said Liu Dongliang, a senior analyst at China Merchants Bank Co. in Shenzhen. “If they can’t get the money they need, more will default.”  

Meanwhile, the companies that are able to sell bonds are offering 6% vs. 3% last year – that alone is enough to spin even semi-healthy companies into bankruptcy. According to a Natixis study, 18.5% of Chinese companies now have interest expenses that exceed their earnings and it's a stunning 33% in the Real Estate sector.  Think it's time to worry?

The real estate sector was leveraged 197% last year and certainly well over 200% now and a study released in May by brokerage CLSA of China's property, mining, manufacturing, utilities, construction, and wholesale and retail sectors counted potential problem debts of 14 trillion yuan ($2.14 trillion) as of the end of 2015. 

Worries about large-scale layoffs, especially in the steel and coal industries, have held the government back from pushing strongly on necessary capacity cutbacks. Instead, state banks have continued to extend more loans, said Francis Cheung, head of China-Hong Kong strategy at CLSA. Cheung estimates that the actual proportion of questionable debts on the books of China's banks stands at 15-20%, compared with the 5.76% total reported by the central bank at the end of the first quarter for nonperforming loans and so-called special mention loans.

The combined effect of new international accounting rules and China's banking regulations means that up to 10.6 trillion yuan in new capital will be needed to cushion the financial system, Cheung said.  "The biggest downside risk to investing in Chinese banks is their nonperforming loans that have yet to be fully reported," said Ken Wong, client portfolio manager at Eastspring Investments, the fund management arm of UK insurer Prudential.

So happy Friday to you!  I'm sorry to be a stick in the mud – I'd love to smash my brains with a large brick so I could join Cramer and the other market cheerleaders in our Corporate Media but, as I said last summer (July 20th), just in time to get our Members bearish ahead of that China crash:

CASH!!! People! Cash, cash, Cash and more CASH!!! I can only tell you and show you that the conditions we are seeing now – INCLUDING the market-boosting government bailouts – are VERY similar to what happened in 2007/8 leading up to the collapse. That is the limit of my ability. In 2007 and early 2008 I also was "wrong" and the markets went up and I said it was ridiculous and the markets went up and I warned people to go to cash and the markets went up and my only regret was that I didn't do MORE to warn people how dangerous the markets were at the time.

Maybe this time will be different – but I wouldn't bet on it!  We expect positive noises from this weekend's G7 meeting and some kind of stimulus from Japan but, more likely than not, this will be the last hurrah for the stimulus crowd and, after that, there will be a reckoning.  

Have a great weekend,

– Phil

 

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