The Market rally - There Will be Blood

The Market Rally – There will be Blood
I notice three dominant trends driving the market the last few weeks
1. Flight from commodities
2. The glass is half full
3. The economy will turn around in 6 months

I can show why each is wrong, but I’d rather follow the market psychology and profit from it. For now, the market will find good news when it tries. Think back to Goldman Sachs in January when earnings were released against the background of an awakening realization that a banking crisis was dawning. At that time, GS’ earnings expectations had been reduced some 70%, and GS beat those severely lowered expectations. The market cheered and rallied. Weeks later, it crashed hard.

Six months later and we are again seeing the market say “Things aren’t as bad as we expected.”
Yesterday, Cisco reported earnings that beat expectations. But they also lowered guidance for the next 2 quarters. And they refused to talk about anything 6 months out. The message being, of course, that past performance may not guide future.
But the very fact that Cisco grew at all became a reason for excitement.

So here’s my thought – as we leave earning season, there will be less news to make the market excited.

The drop in commodities is also very uplifting because the market thinks it is keeping inflation down. In fact, it is more complicated
Commodities are currently the biggest contributor to exports. A lower price disrupts the benefits of higher exports
Commodities are going down because of a stronger dollar. The dollar has firmed – which is bad for global companies that are achieving EPS based on currency exchanges.
Temporary at best. A recent statement was made by a Kuwaiti minister that oil will remain above $100 a barrel. In oil-speak, that means – “oil better stay above $100 or we cut production.”
As commodity prices have dropped rapidly, and the floors have disappeared, investors are staying away. Oil has dropped 20% in 4 weeks (from $147 to $119). Maybe it will drop more. Who knows. Better to wait until it stabilizes for a while. Or, maybe bet that it could drop further. And that’s what funds are doing – oil got pumped up, and now they are dumping.

Since May, the mad rise in commodity pricing has been driven by speculation. Lets just accept that and move on. An example is SemGroup, a hedge fund, that bet against oil and, in order to cover its positions, had to buy up a lot of oil. They lost $2.5B. And they aren’t the only ones. That caused much of the dash from $120 to $147 a barrel.

Before May, however, commodity prices boomed because of the shrinking dollar and tight supplies. A firming dollar will keep commodity prices low. But the ongoing credit crisis requires the Fed to keep monetary policy loose – meaning an eroding dollar. We could easily see oil $150 in 3 months (post US election).

I raise that SemGroup example for a reason. The market can surge or collapse because of companies having to cover positions. A market can collapse because a fund has to sell a lot to raise cash (perhaps because clients are exiting or the fund has to cover margin calls). The rumor is that is now happening in Natural Gas, apparently.

But what if the many players bet on a major collapse and the market rebounded in stead? In that case, a mini-rally would become a major rally as short positions raced to buy stocks to cover their positions. That’s what I think is happening right now. After all, options expiration is next Friday.

The market continues to bounce between 11,100 and 11,600. I thought that it wouldn’t retrace but go down. I was very wrong and our ultrashorts are getting clobbered. But I am investing and not trading, so I am focused on the forest and not the trees. I see no good news:
Inflation jumping at 20+ year levels
Wages stagnating & unemployment rising
Service spending down
GDP flat or negative (as long as you ignore the GDP bought with the stimulus checks)
Housing crisis accelerating (DR Horton yesterday announced deeper losses, Fannie announced today losses 2X expected levels and barely have enough cash to stay afloat)
Credit crisis is accelerating. Consumer credit card defaults are rising
Global slowdown is starting

I find it amusing to read an analyst report on AutoNation that car sales will be a lot better by the end of the year. http://money.cnn.com/news/newsfeeds/articles/apwire/f7a091abf240578cc1a73511ad4d40bd.htm
No facts supporting this. He does not consider the challenges to buying a new car such as tighter lending, no HELOCs, end of leasing, job losses. He doesn’t speak to the fact that car sales were tied to the housing bubble boom. And how is it that the car makers themselves are expecting further drops.

But the sentiment is there. “We are close to a turnaround.” Unless I’m mistaken, the correction just started. How can the turnaround be so close?

So we have disconnect between the euphoria (things are going to be okay) and the reality (things are bad and getting worse).
What do we do while it lasts?
We could jump on the bandwagon and bet on market strength.
Or we could be patient a few weeks and watch things collapse again. That addresses the ultrashorts. I also think commodity flight is ending – they are so oversold it’s silly.