Is End-of-the-World-Trade Unwinding?

The short-covering rally continued on Thursday, as the market continued to rise on bad news and low volume.

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Up days have seen buying on heavier volume, but Big Board volume has been in the 1.1 to 1.3 billion share range the past few weeks. On only one up day, March 20, has volume been heavy.

We have resistance in the 1420-1430 range, which if we hit over the next few days as I expect, the relative strength index [RSI] will be near 70, indicating we are overbought. How the market reacts from there will be interesting. If it consolidates and works off its over-bought condition, I would not be surprised if the market attempted to take out its highs (which I would expect to fail).

In absolute terms, earnings have been poor. In relative terms, earnings have been fantastic as most pieces of news confirm that, indeed, the economy is not on the verge of collapse. This is causing relief rallies as shorts cover. However, there is no conviction buying as money continues to stay on the sidelines.

In the near term, I think the semis look very interesting.

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I think a pull-back in the market is coming. When it does, I may make a long trade in the chips with the intention of covering it a few months down the road. But, we'll see.

The End-of-the-World trade is unwinding as investors rotate out of commodities and the euro and into financial stocks, the dollar and other risky assets. Just take a look at gold:

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Gold, of which I am long, is sitting on a precarious spot. It is down 13% from the top of last month. If it breaks down here, it could fall all the way to the $725-$800 level. However, even at those levels, it would still be in a structural bull market.

Remember that gold fell from $725 to $550, a decline of 25%, in 2006 before this most recent leg up.

Such a decline could very well occur again as this crowded trade unwinds. However, we are reaching a very oversold condition, which may provide a cushion. But an oversold market could get very oversold as we saw a few years back. A 25% decline would put gold at $750, right in the middle of support.

Also remember that even if this trade continues to unwind, gold and other commodities rose as stocks rose into 2007. Even though they may move in opposite directions in the short-run, there is no reason why stocks and commodities would not go up concurrently over the intermediate term.

My base case is for an anemic economy that sputters over the next few years, one where growth is capped as we work off the excesses in the financial markets and credit growth slows, but one that does not collapse either as fairly strong emerging markets, and the lack of excesses outside of the consumer put a cushion under the economy.

This will bring about a trending market, I believe. Stocks will trade in a wide range as we rally off news when we are oversold and the sentiment is too negative, then decline when expectations for a return to trend does not materialize and optimism is too great. This will be a stock pickers market, evidenced by those who can pick Apple and avoid Starbucks.

Though my positions are approaching their stops (sell triggers to limit downside), the commodities bull market is still on. Commodities may be in for a choppy few months, but like any structural bull market, declines should be seen as opportunities.

Comments

[Alan Brochstein]

Toro, I am with you on this one and am very heavy into the Financials. I think that your volume comment about the NYSE may be true, but the NASDAQ has shown good volume. I learned a long time ago not to fight IBD, and they continue to suggest we are in a confirmed rally.

I would add small-caps to your list of beneficiaries of the end-of-the-world trade, as the poor liquidity has impacted them more than the larger companies. Further, if the dollar does indeed retrace some of the weakness, it could benefit small-caps as well due to perception changes about export strength.

While I agree with your comment about the economy over the coming years, I wonder if what the implications are for the market. I view it as somewhat like "goldilocks" is back. I don't expect a soaring market, but the market usually does well after a decade of flat returns. I am intending to do some work on historical headwinds, such as we face now, by looking into the drag created by the defense budget slashing in the 90s and some other events. Treasury rates, will likely to elevate as part of this unwind, are probably going to stay constrained for some time. Inflation shouldn't be an issue given the economic slowdown and the continuing headwinds.

As always, thanks for sharing your thoughts!

Alan

[Ames Tiedeman]

The Sox is back. It will rally all summer too..

[galewhitaker]

Ames Tiedeman
I read that that the techs get half of their revenue directly from the consumer. The consumer can't afford to buy anything but gasoline to get to work. Where is this consumer guy going to get the bread to buy flat screen TVs and navigation gear when he is paying $100 for a fillup? I think the techs are going to take a big haircut. Remember that stocks are only cheap when they are earning the big bucks. They get infinitly expensive when they start losing money.

[Matt Blackman]

Interesting overview and comments on volume. Overall volumes have been lower but prices have held which reminds me of the old traders axiom to never short a dull market.

I do disagree with your statement, "In absolute terms, earnings have been poor. In relative terms, earnings have been fantastic as most pieces of news confirm that." That is just simply not true. There have been pockets of strength (like Google and IBM) but overall earnings continue to deteriorate and since it is earnings expectations that drive stock price, stock prices will be weak until earnings turn around. Here is my take from my newsletter last week.

"There may have been a few positive earnings surprises to get investors excited this week but overall, Q1-08 earnings continued to trend lower. According to Bloomberg, profit exceeded analysts' estimates at 58 of 101 companies in the S&P 500 that have released first-quarter results so far this earning season and this is what has excited investors. But earnings fell an average 37% from a year earlier. S&P500 Q1-08 earnings are forecast to decline 13.7%, which if it comes to pass would make it the third straight quarterly decrease. Looking at the broader picture, as of the second week of Q1-08 reporting season a total of 678 companies have now reported and average earnings fell 22% from the same quarter a year ago compared to a drop of 17% last week with 421 companies having reported. This compares to a drop of 57% for Q4-07 (3900 companies), a 21% drop (4205 companies) for Q3-07 reporting season and a 13% jump in Q2-07 (4211 companies). (Is it a coincidence that the total number of companies has dropped each quarter?) " (See Figure 4 in column "The Trouble with Earnings" tradesystemguru.com/content/view/160/61 / )

[Bhakta]

Interesting article. I can't disagree with what you write. I am staying long on gold and silver, and on energy and not getting too disturbed by the sell off. The last few years gold always drops until the fall and then resumes its upward move. Seems this year is not different. I also do not think the financials will recover significantly their earning power anytime soon.