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Why Are We Up? Risk Still to the Upside

Today is very much like a seasonally August day, with no news being the main driver.

How can this be? Because after a decline of the last two weeks, many traders think the risk is on the upside. "There's nothing for sale today," one trader told me. "No one can afford to stay out of the market in the event something happens tomorrow."

Range-bound? I noted last week that one of the factors turning around sentiment were reports of significant insider buying and buybacks. That was as good a sign as any of at least a short term bottom.

Charles Biderman at TrimTabs.com noted that insider buying spiked on August 4th, when the S&P plunged below 1,200. He also noted that insider SELLING spiked up when the S&P crossed over 1,300 in February and again in April.

Mid-day, we are exactly at 1,200.

Second-guessing Merkel. Meantime, traders have been feverishly trying to figure out where the game between Merkel, Sarkozy and the rest of Europe will be going in the next few months. Not tomorrow: Merkel will be obdurate as usual.

But few traders believe that just expanding the European Financial Stability Fund (EFSF) to a little more than $400 billion euros will ultimately be sufficient. It certainly isn't big enough to help Italy, or even Spain.

That's why traders keep throwing around $2 trillion for the EFSF: $1.4 trillion for Italy, $600 billion for Spain.

The big issue is that Italy soon will be unable to afford to borrow the money it needs. That's why Italy's Berlusconi is trying to push through fiscal reforms with a balanced budget by 2013, along with labor market reforms that would make it easier to hire and fire workers.

Problem is, most traders still don't believe this would be enough to significantly hold down the rate they will have to pay.

The choices for Europe:

1) Monetize the sovereign debt of troubled nations by printing money. The European Central Bank (ECB) is not allowed to do this now, but it may be empowered to do so in the future.

2) A more formal fiscal union by issuing eurobonds. Members would then be able to fund a certain portion of their finance needs using bonds that would be the collective responsibility of all the euro zone members. This sounds appealing, but why would more fiscally conservative governments like the Germans or the Dutch want to back their more profligate neighbors? Why would the Finns, for example, want to issue eurobonds and pay a higher interest rate than they are paying now?

The answer is, they wouldn't, and that's the biggest problem: it would require the approval of European parliaments, and would face determined opposition. It may have a chance to succeed, but only when faced with the imminent dissolution of the euro.

3) Bring in outside agencies like the IMF or the G-20 to share the burden. This sounds appealing too: ask the rest of the world to help out. But the IMF would certainly require a pound of flesh in the form of tough fiscal controls. The Europeans would bristle because they would have to give up control over at least part of their union.

Here's the weird part: none of these choices sound appealing, but most traders think that ultimately—not tomorrow, but down the road—some combination of all three are likely to happen.

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