Markets Rally on Hope Trade?

As the statement goes, hope is not a valid investment thesis. Yet, that appeared to be the case on Friday morning. Markets in the US traded higher on Friday—at one point, the Dow Jones Industrial Average was up over 100 points. The financials enjoyed strong bullish activity, rallying the most of the major sectors. Hope that Europe would be able to solve its ongoing crisis may have propelled the markets, although volume was admittedly low on a half-day. Around 11:30am, headlines began to leak from the Eurozone leaders. Although no comment was particularly bearish, they may have crushed hope investors had for any clean solution. The Finnish Finance Minister stated that—for her country—euro bonds were out of the question. The European Central Bank's Paramos stated that it was not the responsibility of the ECB to save the euro area, and that demands for additional liquidity were "out of the question." Those comments may have been enough to zap buying pressure from US markets, as the Dow moved back down closer to unchanged on the session. Additionally, chatter circulated that Greece was talking to its creditors pushing for an additional haircut. The country had already been granted a 50% haircut earlier, but is now apparently pushing for a 75% haircut. With some in Portugal and Ireland calling for a similar deal, a further haircut on Greek debt may exacerbate the contagion effect, as other troubled nations push for even more debt forgiveness. Ultimately, however, with major countries like Italy struggling to repay and even some commentators believing that France could even be in trouble, the demands of smaller countries like Greece may be largely irrelevant in the broader picture. The creation of the Eurobond may be enough to stem the crisis. Under that system, the debts of troubled nations would be tied to those of the stronger ones, thereby reassuring creditor that, even if the Greeks cannot repay them, German and French taxpayers would be there to repay. Of course, even that solution may prove ineffective. On Wednesday, a German bond auction failed. Although the inability of Germany to repay on its debts seems outside of the mainstream, market participants may already be factoring in expectations that Germany will be on the hook for the debts of other European member states. ACTION ITEMS:

Bullish:
Traders who believe that Europe will find its way out of the mess, might want to consider the following trades:

• Go long US financials. Financials in the US have been battered by speculation that Eurozone defaults would cross the Atlantic. Bank of America BAC, in particular, as it hit a 52-Week low on Friday.

• Go long industrial commodities. Although oil has held up throughout the crisis, other commodities like copper have traded lower, and could rebound if the economic growth picture improves.

Bearish:
Traders who believe that the European situation will continue to get worse may consider alternate positions:

• Short financials around the globe. The stocks have already been badly beaten, but they may continue to move lower if the European situation worsens in severity.

• Short oil. Oil has held up, perhaps on Middle Eastern stability concerns, but if global recession is in the cards, the demand for oil may evaporate.

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