First and most important takeaway from today's action: We were a heck of a lot closer to DEFCON 1, an actual collapse of credit than even I, stuck at DEFCON 3, thought. That's right, this unprecedented financial cavalry, led by Federal Reserve Chairman Ben Bernanke, charged to Europe the way Pershing strode into France because it looked the allies were about to go down.
I think we would have seen a Lehman Brothers "event" in the next 10 days, had this not happened, especially because lending to almost all of the manor banks in Europe had simply died.
The only funding they had was so expensive, until today's action, that I would have expected one of the major banks to seize up and close in a very short period of time, especially because European leaders were on the verge of doing nothing. That's how I describe their initiatives last night before the coordinated effort that started with a Chinese rate cut, and then went to our combined efforts with the Japanese, Canadians and Swiss. Nothing less than a total abdication on the issue.
That's why the rally could be so huge today. Not only has it, at least for now, taken off the table an instantaneous Lehman event, it allowed us to trade off a series of better-than-expected pieces of data, such as The Chicago Purchasing Managers' report, the actually strong existing home sales, and an unequivocally strong ADP employment report, hopefully -- at least for the bulls -- a precursor to Friday's Labor Department Report.
I keep hearing one question and one question only, now that we have staved off DEFCON 2, let alone DEFCON 1, can you keep playing the rally? I have to answer it in a bifurcated way. I have said that you can own quintessential American companies like retailers, the oils because demand remains high and geopolitical tensions are mounting, courtesy of Iran, and the higher-yielding stocks whether they be in industrials, MLPs or health care. I believe that some of the most beaten-down Chinese-related industrials and discretionary income plays, such as Cummins (CMI), like Starwood (HOT), which is building 100 hotels in China or even a Wynn (WYNN), which I thought was on life support the other day, can be owned simply because they are down so much because of China, and the Chinese are now taking care of business.
However, I think you should use this strength to lighten up on the banks if you still own any and here's why.
The global cavalry, or the Financial D-Day if you want to go past Pershing and analogize to Ike, has responded only to one front, which I can regard as the Western Front -- the banks that have taken down huge amounts of sovereign bonds and have a gigantic amount of bad loans. But it is the equivalent of the much worse Eastern Front that I am worried about. That's the sovereign debt. You can keep the doors of banks open, but that doesn't make me want to own them. Without a concrete solution to the sovereign debt problem, you are not going to be able to save Europe from a severe downturn because it all begins and ends with the colossal amount of debt that could be defaulted on, the one that we measure by the strength in the euro, which, not remarkably isn't up that much.
It shouldn't be. A save of the private sector, for now, won't last if the public sector is not able to restrain spending, and get lower interest rates, perhaps with the help of a now shamed European Central Bank (ECB) to help. The war cannot be won on the Western Front. It isn't inconsequential, but without a victory in the sovereign front it could all be for naught.
The U.S.-led invasion force must be used to shame these countries into action. The Germans must see that we, and it is we, saved their banks, so now they have to offer some coherent plan, not some silly stop-gap can-kicking, to deal with the transition from ever-rising budget deficits to actual declines in budget deficits accompanied with the possibility of some growth.
To that end, we have to be encouraged that the Chinese have now begun a rate cutting cycle that could be huge for Europe, taking off 50 basis points from a skyrocketed 21% reserve requirement. While Europe's economic fortunes aren't directly tied to China, we know from the last credit crisis, that China can boost world economic growth and even the caboose gets pulled along with that.
So what has to happen? We need to see before some huge Italian and Spanish bond auctions occur in the ensuing weeks, some coordinated action led by the Germans to print European bonds, perhaps with amounts up to two trillion to three trillion euros -- yes, that's how big the problem is.
If this is done, then I believe some forces in the private sector will take Italian bonds that yield 8%. This morning on "Squawk on the Street," I interviewed Jim O'Neill, the Goldman Sachs strategist who originated the term "BRICs" a decade ago, who said that he would actually think about wading in to buy Italian bonds because Italy is solvent if the momentum continues. That's major. He's listened. . You get some momentum behind this move, you get shame to afflict its wonderful ways on the intransigent Germans, and you get a start toward something bigger.
But, and there is always a but when it comes to Europe, the possibility that the Germans do not play ball, the possibility that the ECB takes no action, the possibility that the authorities do not use this U.S.-inspired invasion to take action, is probably about 50-50%, no more than that. So, I am staying at DEFCON 3 until I see otherwise, if only because disappointment has been the only M.O., when it comes to Europe and it is only because of brave people like Ben Bernanke that we even had this rally at all.
So, you can stay long retail, the oils, the higher-yielders and selected Chinese-related plays to take advantage of what could be a prolonged interest rate cutting cycle, but begin to sell those that aren't even as high yielding as they were on Friday, prune back some tech that has moved up where the fundamentals are weak, and, once again, take advantage of the desire to fulfill Tim Geithner's pledge to me of no more Lehmans, and lighten up on the financials. If they rally I can only imagine how strong the move up in everything else will be.