Strategic Thoughts on the Major Indexes

Includes: DIA, IWM, QQQ, SPY, TWM
by: John Henderson

The counter-trend rally which began in early July is over; the second down-leg of this bear market has begun. Although some may wish to think that this past week was just a necessary correction after the big rally of the past six weeks, we unfortunately do not see things this way. In addition to numerous data points suggestive of an economy that may be hard pressed to show any positive growth in the second half of this year, this past week saw significant deterioration in the technical underpinnings of the market’s structure. Because the technicals take precedence over the fundamentals during a bear market, we would like to spend some time reviewing what has taken place this past week on this front.

One of the more troubling aspects to the action over the past two weeks resides in the small-cap index, the Russell 2000. The de facto leader for the market since last Spring, the Russell has now become the leader to the downside after its 6.3% break this past week. As things stand now, this small-cap index is poised to be the first of the major indexes to crack below its July lows.

Due to the over-extended near-term nature of the Russell 2000, we have only taken a probing position in the inverted Russell 2000 ETF, [[TWM]]. We plan to add to it on pullbacks as the Russell 2000 rallies back to the 635-640 range one last time. Because it is an inverse ETF, those wishing to short the Russell should go long the TWM. Our initial target zone to cover the TWM short in the Russell 2000 is 570-580.

Turning to the Nasdaq, we expect that this index will be the second major index to crack its July lows at some point after Labor Day. Later this year, Cisco’s (NASDAQ:CSCO) “unusually uncertain” outlook for its upcoming quarter will ultimately be looked back upon as the first “shot across the bow” for the tech sector’s 2nd half decline. In addition to the burgeoning problems in the networking space, according to J.P. Morgan, the demand for PCs has recently fallen off of a cliff. This bodes very badly for the entire PC food chain, including the electronic component makers, the semiconductors, the EMS providers, and for the likes of Intel (NASDAQ:INTC), Microsoft (NASDAQ:MSFT), AMD (NYSE:AMD), Dell (NASDAQ:DELL), and HP (NYSE:HPQ). Watch for one final test and failure of the Nasdaq’s 50-day SMA to the upside in the next week or two.

With the elections coming up and the Fed’s recent renewal of Q.E. Part II being met with massive selling, we expect additional governmental and Fed actions either before or after Labor Day. Such moves would result in a massive short-covering rally in the Nasdaq back into major resistance at its 50-day SMA – slowly scale into short positions during such a rally. We favor shorting QQQQ as a general proxy for shorting the Nasdaq.

Turning to the S&P 500 and the Dow, it seems clear that the big money is hiding in these indexes for the time being. With time, this will change. The banking sector seems ready to crack; downside in this space will inevitably lead to selling in most other blue chip areas. Even with this expected downside, respect needs to be given to the strength in these two indexes in the near-term.

Although we expect them to ultimately play catch up with the Nasdaq and the Russell, for now, we have no interest in shorting these indexes. With many of these names levered to the worldwide economy, we feel that earnings will hold up a lot better for bigger, internationally focused companies than those with a particular bias to the U.S. economy, i.e. the Russell 2000 companies.

We have three weeks left in the summer before the big money returns in earnest. In our view, the selling will pick up after Labor Day as estimates continue to get cut and the market comes to accept the fact that Q3 and Q4 numbers are simply too high.

From a strategic perspective, we remain in high levels of cash for the accounts we oversee. We are going on vacation in two weeks and feel confident that the market will present a number of short-sale opportunities when we return. We are therefore not going to recommend a host of new names to short right now. The market is simply too extended and we would like to wait for some silly rallies before we sell into them after Labor Day. Plus, we are headed away to the beach in two weeks and are looking forward to some down time away from this craziness.

Disclosure: Short Russell 2000 via TWM