10-17-2011 Market Commentary

By Eddie Katz

Barron’s - Stocks soared 6% last week on relatively low trading volumes, as continued short-covering helped the market put together two consecutive up weeks for the first time since early July. Though the rally is young yet, already some participants doubt its longevity, given that much of the activity appears to be computer-driven momentum-buying and short-covering, not some Niagara of traditional buy orders. Moreover, while third-quarter earnings reports came in as expected, the sovereign-debt situation in Europe could deteriorate in a heartbeat. Consequently, many institutions remain on the sidelines, traders say. Nevertheless, no one will reject a rally after the past 10 weeks of troubles. The fact that the market moved so much on less-than-strong volume and on little in the way of real positive news gives rise to skepticism, traders say. Christopher Zook, chief investment officer of CAZ Investments in Houston, concurs: "It's not like the European situation has been solved. It's feeling like a bear trap."

Morgan Stanley - Bear markets always have bear market rallies. For example, the sharp corrections on the NASDAQ in 2000-02 saw eleven 10%-plus rallies – including three over 30%. It signals that while it may be right to remain strategically bearish – as we are – this tactical move could have further to run. Yes, there is some modest sign of progress in Europe, but as we and our colleagues have argued, there seems little prospect of a ‘silver bullet’. A long-term resolution of the crisis would, in our view, require material bank recapitalization, recognition of bad debts, closer fiscal links and more aggressive ECB monetization, little of which appears likely in the foreseeable future aside from bank recaps. Better US macro data have also supported markets, but there too some of the strength is due to temporary factors (rebound from Japan disruptions and bring forward of investment spending ahead of tax break expiry). We expect material earning misses in coming quarters, and don’t believe absolute valuations are cheap enough to be strategically bullish, given obvious risks. Tactically, we can see further upside. The news at the margin, while not decisive, has been better: central banks are responding (ECB repos, Fed ‘twist’, dollar swaps, rate cuts in EM), and incoming macro news has, on average, stopped surprising on the downside. We are monitoring sentiment indicators, positioning and performance to sense when this rally has squeezed in enough investors to think that the risks have tipped to the downside again. We are not there yet, and the process may take some time (1-2 months).

Merrill Lynch - The bulls finally make a stand. Last Tuesday's low 1075 on the S&P 500 marked a lower volume test of the early August low near 1100 and this is an early sign that the US equity market is trying to form a bottom. This is encouraging, but the risk is that the market has not yet seen the explosion in volume that typically comes with a climactic capitulation. In addition, last Thursday's and Monday's 90% up days occurred on lackluster volume. This suggests a lack of conviction from the bulls and likely points to short covering, which is not the recipe for a sustainable rally. Once a bottom is formed it usually takes several months to complete a bottoming process. This process can involve additional tests and/or undercuts of the 1100 and 1075 area lows. In the late October 2008 to early March 2009 the basing process from the climactic low in October for the S&P 500 undercut the prior lows by 10% to 12%, which suggests that a probe into the 985-910 is not ruled out. The 1020 area also remains a key support level. Resistance within a basing process for the S&P 500 is the 1170 to 1235 zone. Additional resistance is 1260.

Barron’s - Don't look now, but a recent gauge of the economy is sending some worrying signals to the economist who helped create it. In September, the Ceridian-UCLA Pulse of Commerce Index, which tracks real-time trucking activity, fell for the third month in a row, this time by 1%. The result hit Ed Leamer, a professor of economics at UCLA who was one of the index creators, like a "slap in the face." The index fell 1.4% in August and 0.2% in July. All told, the second-quarter decline came to an annualized rate of 10%. That rate of decline was exceeded only in the deep recession of 2008 and 2009, and was equaled only once outside of a recession, in March 2000. Leamer still isn't a "double dipster" because the economy isn't sending the signals he deems necessary in housing and durable goods. But he does concede that three downbeat months "adds up to a magnitude that's as big as anything we've seen except in a recession." Moreover, the reading for the end of September was worse than the beginning of the month, which indicates the first part of October will be weak. Leamer has some explanations for the latest decline, including the possibility that more truck shipments have moved to the railroads. But he himself debunks that hypothesis, saying that such a move doesn't happen quickly enough to produce such a big decline. "If there's any good spin to put on it, retailers may be holding back on inventory restocking," the economist theorizes. Leamer will be closely watching October's reading, as well as the industrial-production report, due out Monday: "If that's negative, it could be the official beginning of the recession."

Conclusion – If we were any good at day trading, when we stated “anyone up for a possible trip to 1,250 from the current 1,155 on the S&P 500” last week, we would have mentioned that the majority of the up-move would occur within five trading days and that you should go long on margin. But since we didn’t, we’ll just have to take comfort in feeling that our thesis seems to be playing out thus far. Take a look at any stock market chart for the last three months and you’ll understand why we have had more comfort lightening up on risk during strength versus buying the dips. At this point, the one factor that would have us worried that our caution is unwarranted is if the FED and other global central banks somehow create inflation, which would be a positive for stocks. To date, most of these institutions have been inept at doing anything so we aren’t too concerned. On the flip side, what keeps us grounded with our “underweight risk” stance continues to be (in order) European sovereign debt, the 99% (new to the list!), global austerity, supply glut of houses and that pesky problem of unemployment. So despite the stock market appearing to wave an “all-clear” flag this week, we want to remind you that the same flag was waved on 8/12, 8/26 & 9/16 after stocks finished those weeks with 5%(ish) rallies. Buy fear and sell greed…and after last week’s rally, we can tell you that the natives are starting to get a little gluttonous.

Regards

eddie