Traders have gunned the market higher over the last two weeks courtesy of:

1)   Short covering

2)   The Euro rally on French liquidity concerns

3)   Rumors of yet another Euro bailout

Regarding #1, short interest on the NYSE was at March 2009 levels going into this rally. With this kind of short interest, even a small rally will become explosive as the shorts cover (buy stocks)… which sends the market higher… which in turn results in more shorts cover.

This same dynamic is playing out for large financial institutions in France resulting in #2. French banks are facing major short-turn funding shortages. As a result they are selling long positions and covering shorts to free up capital. Because of this, the Euro is rallying hard, just as the US Dollar did in 2008 when the US banking system was in collapse.

Because stocks are moving in lock-step with the Euro, the Euro move has pushed stocks higher in a big way.

Finally, regarding #3, it is obvious to anyone that the EU is completely out of ideas that will possibly work. The kick the can mentality is ending. I know Merkel and Sarkozy claim to be working on some great plan to fix things… but the reality is that if those countries do go for the leveraged EFSF then they will lose their AAA status… which comes with its own set of major problems.

Will France and Germany go “all in,” and choose to lose their AAA status to bailout Greece again? Hard to believe that will be the case. And we see reports emerging of Germany preparing for a Greek default and bondholders taking a 60% haircut.

It is literally a case of “pick your poison.” If Germany and France backstop Greece again with the leveraged EFSF, they will lose their AAA statuses and we’ll see a bloodbath in Europe. If they don’t backstop with the leveraged EFSF, we’ll see a bloodbath in Europe.

With that in mind, the Euro is coming up against major resistance at 140:

We’re facing a quick correction here to 135 if not 130 in short order. Long-term I expect we’ll see Greece default followed by a domino effect in which all bankrupt European nations restructure. When this occurs the Euro will break below the 2010 lows of 118.

In terms of stocks, we’ve been in a large trading range between 1,125 and 1,220 on the S&P 500. We’re now testing the upper end of this range, which sets us up for a return to the low end of the range.

Given the economic backdrop in the US and Europe, I remain convinced we’re breaking out of this range to the down side. I’ve warned to get defensive for over a month now. This week looks to be a good time to add to shorts as I expect we’re going to likely see a top put in as earnings season kicks into higher gear and the usual options expiration nonsense ends.

However, larger picture, I believe we’re facing systemic risk… as in another 2008 event. The most likely culprit for this will be Europe, which is literally on the ledge of a cliff.

Indeed, the facts remain that Greece will default. End of story. Greece is broke. The market knows this which is why it’s pricing a Greek default at 100% guaranteed.

Once Greece defaults, Spain and Italy will follow suit. When that happens we’re facing a situation that will make 2008 look like a picnic. The powers that be know this… which is why the IMF has warned we are facing a “global financial meltdown.” And the Bank of England says we’re facing the “worst financial crisis in history.”

Folks, these are the guys in charge of holding the financial system together… warning that we’re facing a meltdown. Did they do that in 2008? Nope. So how bad are things going to be? BAD.

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