Bears Strike back

Market Commentary:

Even though the markets are in highly oversold territory, another bit of poor economic news and another advance by the dollar hit equities as hard as any day since the rally began – only matched by a strong down day in early July.

Small cap stocks were hit the hardest with the Russell 2000 ending at -3.51%, the Nasdaq Composite at -2.67%, the S&P 500 at -1.95% and the DOW at -1.21%.

It is fair to say that the decline was broad based and continual all day long with indexes closing at or very near the lows of the day.

Investors have been giving credit to companies for their cost cutting measures during this entire rally. But I think things are starting to change. Even though several companies reported better than expected today, it had no effect on their share prices as a worried pale hung over the markets.

During this Q3 earnings period companies have bested analysts estimates for 82% of the companies reporting in the S&P 500, which would represent a record percentage going clear back to 1993, according to Bloomberg data.

So why the gloom and doom the last couple of weeks? (I can hear you saying “the dollar”).

I think investors have finally reached that point where better than expected is yesterday’s news and if you can’t bring in a better top line and an increase in profits, then you probably can’t going forward, either. As if this needed any confirmation, profits on these companies who have reported have decreased 19% on average. Sales have slumped almost 6% and consumer sentiment leads anyone to realize that Q4 is likely to be even worse for real profits.

“ The stock market has gotten ahead of itself and to sustain those values going forward we’ll need to see real economic growth,” said Peter Jankovskis, from Oakbrook Investments. “The weakness in consumer spending is still the key issue to be resolved.”

But the real pressure on the stock market today was an unexpectedly poor New Home Sales report, which showed a 3.6% drop this month, versus a 1.0% increase last month.

If you were a new home builder you would probably be real careful in 2009 about building a new spec home. Builders have approximately 251,000 houses on the market, the fewest since 1982. And with sales levels this low it would still take 7.5 months to sell these homes.

The fact that actual housing starts are at historic lows should be evidence that builders do not see future demand increasing enough to gamble on putting very many new homes up.

Let’s think about why we have a sudden reversal in what was looking like a housing bottom and/or new growth environment. We don’t have to look far to realize that this drop in sales should have been “expected” rather than “unexpected”.

The home buyer credit program is due to expire in November, suggesting that the growth in new home sales this summer was nothing more than an effort which brought what little demand there was forward a couple of months.

This is the problem with many stimulus programs that most analysts and every government official somehow seem to overlook. Often these programs are not actually creating any new demand. They are just re-locating the demand, and at a heavy cost to the taxpayer.

When the stimulus runs out then the demand runs out as well. Perhaps a “real” growth at a “real” rate is more conducive to a recovery than a fake demand that has done nothing more than move demand forward.

I have a bet you can make, though. I guarantee that this sudden drop in new home sales will be incentive enough to convince our congress that they must suddenly act to extend and even expand the housing credit program … perhaps for a very long time. They know now that once you take the bottle away, the baby is going to cry and public officials do not like crying babies.

There was other economic news, it just took a back seat to the housing data. Durable goods were up 1% in September, in line with expectations, but of little significance on a day like today.

The big elephant in the room continues to be the dollar. It was up again today:

As you can see, once the markets opened (9:30am) the dollar began another relentless climb throughout the day, only to drop back in after market hours. From this chart you can see that the dollar climbed from around 76.22 near the market open to 76.68 just before the close.

Why would such a small rise in the dollar create such a large move in the markets? Let’s look at it from a larger perspective.

Before this 6-month rally began the dollar was very close to $90. At the high for this rally on October 19th the dollar had fallen to a low near $75. This represents a 16.6% drop in the dollar.

During that same time frame the S&P 500 has seen a 62% increase (low to high). The ratio of the S&P 500 price change versus the dollar price change was just under 4 to 1 (4:1), suggesting that a four to one average is to be expected, and oftentimes much greater and much smaller ratios will be seen.

I recently read an article indicating that the falling dollar has actually reached an undervalued state. The inference in the article is that the dollar is likely undervalued to the tune of at least 7-11 percent.

If the dollar rises to correct this undervalued condition, it could mean that the dollar will end up somewhere around $80 to $82. Based on a 4:1 ratio, that means that the stock market could easily fall 30-40% from the high seen in October. This is easily in keeping with traditional Fibonacci retracement percentages, as well.

While all this may sound very depressing, and it might be for the longer term outlook, the markets are highly oversold right now and the potential exists for a significant spike rally.

Like I have explained in the past, when short positions begin to dominate any buying brings out a huge short covering effort so those short oriented gains can be pocketed. This usually requires buying securities to cover the short position, and the end result is a strong advance.

We may very well be looking at a strong advance in the short term, but a challenging environment in the longer term. I have a lot of evidence to support this thinking and will offer it as the days go by.

Here is some technical evidence of why a sharp advance could occur anytime:

This chart shows that the prices for the S&P 500 have reached a significant support point. The headlines will show that the S&P 500 has broken below its 50-day moving average, and that does not bode well for the longer term picture.

But if you look closely at the dark black line I have drawn you will see that the S&P 500 landed precisely on this line, suggesting that a bounce could be next.

Another indicator strongly shows oversold conditions and suggests a strong bounce, too. It is the Nasdaq McClellan Summation Oscillator:

The line to the far right has reached a low that is actually much lower than it reached last March or November of 2008. While the chart does not show it, the only lower value set in recent years was set in October of 2008.

When this indicator is at this low of a value it usually means that a spike rebound or at least a decent short-term advance is queued up.

The problem with this indicator reaching such a low level is that for the long term is means that there is great potential weakness in the longer term picture.

So, in summary, a short-term advance could be sparked on any positive excuse while a longer term decline seems to now be in the cards, as well.

Our headline event for tomorrow is the preliminary Q3 GD, which most analysts have pegged to come in at 3%. Goldman announced earlier today that their research suggests that the number will be lower, around 2.7%.

Did Goldman lay a goose egg down today so they could profit from their short positions, which they could easily cover tomorrow and gain on the long positions (calls) they are likely to make tonight?

Be ready for a volatile day tomorrow. It may set the tone for the next week or so.

Remain cautious. This is not a time to take on short positions – you are likely to get killed in a spike advance rally. This is also not a time to buy the dip – this is too big a dip and there is strong evidence that equities are going to struggle in the coming months. If you buy, be ready to sell just as quickly.

The best advice might be to get ready to shed whatever long positions you have in case this next advance quickly fizzles out.