Upside Window Closing: Initiating Shorts Now

 |  Includes: AAPL, DIA, INTC, MSFT, QQQ, SPY
by: James A. Kostohryz

Last week I spoke of several catalysts that could have driven an extension of the October rally. For the most part, none of these potential catalysts have materialized. Let us review:

1. Portfolio rebalancing. Sentiment had been overwhelmingly bearish going into the October 27 euro summit. Portfolio managers were caught short or underweight equities. Many had to purchase equities in order to neutralize these bearish bets. Various sentiment surveys suggest that the reversal in sentiment from bearish to bullish has largely run its course. Having said that, portfolios on aggregate are probably not positioned in an overly bullish posture as shifts if this nature generally last more than a couple of weeks. Still, much of the upside impetus provided by bearish sentiment has been blunted.

2. Fed meeting. QE3 will not be providing upside impetus in the short term.

3 G-20 Summit. This meeting was an utter disappointment, to not call it a failure. No commitments were obtained to “leverage” the EFSF. Furthermore, Italy formally rebuffed IMF demands for more austerity.

4. Follow-up policy actions in Europe. The plans announced on October 27 are completely on hold until the Greeks sort out their political drama. In the meantime, independent of this Greek soap opera, the follow-up on the European plan to use the EFSF as a first-loss insurer to raise a “bazooka” fund suggests that the initiative is dead in the water.

5. U.S. economic resilience. The news this past week was not spectacular. However, the U.S. economy is doing better than many feared one month ago. Manufacturing and service sector activity are chugging along at modest levels. Employment gains were substantially below what are needed to keep the unemployment rate from rising. However, unemployment claims and the Household Survey point to some signs of life in the labor market. All in all, the data paint a picture of an economy that has thus far been able to admirably withstand some major shocks. However, the data is also not strong enough to warrant any great enthusiasm. Overall, U.S. economic performance has been a plus for the equity market.

6. Super-committee. This remains a potential positive catalyst, in my view. Expectations are so low that an upside surprise would seem more likely than a downside surprise.

Despite my bearishness due to the situation in Europe, I have been hesitant to put on any major short exposure. Sentiment was too gloomy and a number of substantial potential catalysts from the EU summit through the G-20 Cannes summit provided potential fuel for an extension of the October rally.

Many of the potential catalysts have not materialized, and the window an extension of the rally appears to be closing.

In the meantime the fundamental situation all over Europe is deteriorating at an accelerated pace.

On Friday, I initiated substantial bearish positions for the following reasons:

  • Collective weekend reflection. I believe that this weekend will provide investors with an opportunity to reflect on the fundamental outlook for global equities in the next few months, and as they do, the conclusions are unlikely to be encouraging.
  • Running out of catalysts. The G-20 meeting provided the last major opportunity for European leaders to generate global policy momentum behind their plan announced on October 27. The meeting was a failure. In the meantime, the U.S. Fed will be on hold for a while.
  • Greece drama to continue. No matter how a new government is constituted, Greek political and economic behavior will continue to completely befuddle European leaders. As their economy contracts further, the Greeks will continue to miss fiscal targets due to shrinking revenue. Furthermore, the political and social situation in Greece is likely to remain unstable, at best.
  • Portugal to come into focus. Not enough attention has been paid to Portugal. The situation is dire and traders are likely to set their sites there soon. The world will soon realize that Portugal's crisis of a similar magnitude to that of Greece's and may derive in the same sort of consequences.
  • Italy danger to grow. The market is not fully appreciating the bind that Italy is in. If the current center-right government cannot push through austerity measures and labor reform, then it is very clear that a center-left government would be even less likely to implement such reforms. In the meantime, the Italian economy will likely contract sharply, and this will set off fears that Italy will miss its fiscal targets. Italian bond yields have sustained themselves beyond 6.20% despite ECB intervention, suggesting that those yields might be approaching 7.00%, if not for the interventions. I believe that if yields surpass 6.7% for any length of time, without a forceful response by the ECB to bring yields below 6.00%, the situation will likely spiral out of control. Higher yields are further choking off the Italian economy and are also dramatically increasing interest costs which are a very major part of Italian fiscal expenditures.
  • EFSF insurance fund floundering. The only way to “leverage” the EFSF is if investors purchase the bonds with the EFSF. All indications are that investors have no interest in these bonds. Thus the entire plan to leverage the EFSF seems dead in the water.
  • Commodity signals. On a beta-adjusted basis, commodities, commodity-oriented stocks and cyclical sectors have badly lagged in the recent relief rally. These sectors did not retrace nearly as much of the decline as the broad indices and have remained in clearly defined downtrends. Thus, the price signals contained within the commodities and cyclicals complexes suggest a continuation of the global equity downtrend.

The bearish short positions established were as follows: January puts on XLB, DBC, XLY, IEZ, GDX, (NASDAQ:AMZN).


The October rally was primarily a technical phenomenon that was supported by fundamental catalysts of an extremely tenuous nature.

From a technical point of view the rally seems to have lost some momentum. The swiftness of the decline from 1,292 all the way to 1,215 on the S&P 500 (^GSPC) points to the fragility of the steep, but relatively low volume October advance. Having said that, I am looking for a breech of the 1,183 level on the S&P 500 – the 50% retracement level – as a more definite confirmation that the uptrend has been broken.

From a fundamental point of view, the picture in Europe going forward looks extremely bleak. As traders and investors come to terms with the fact that the situation in Europe will be getting far worse before it gets any better, I expect the market to grind downward in a volatile and erratic fashion interrupted by sporadic hopes of policy action.

The current situation in Europe seems largely a repeat of the pattern between mid 2007 and mid 2008. By mid 2007, it was clear that the U.S. banking system would collapse without massive government intervention. It took a year until financial markets fully assimilated this fact and markets finally collapsed. It was only after markets had rendered their frightful verdict that policy makers were finally spurred to take drastic action. European policymakers seem to be following the same script.

I reiterate my view that the U.S. equity market (^GSPC, ^DJIA, ^QQQ) will initiate another major leg down within the next six months that will test and most likely violate the recent low of 1,075. I expect U.S. equities (SPY, DIA QQQ) to ultimately fall to a level between 950 and 1,020 on the S&P 500. It is my view that investors will best be served to wait until that time to take positions in strong and fundamentally attractive companies such as Apple (NASDAQ:AAPL), Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT).

Disclosure: Short XLB, DBC, XLY, IEZ, GDX and (AMZN).