Financials To Resume Meltdown Momentarily

by: Jason Schwarz

On the 16th of July, Lone Peak Asset Management initiated a buy recommendation on the S&P 500 when it was at 1,214. Since then, the index has risen 7% to 1,305 and we have exited the trade. The mantra of this bear market is 'buy the dips and sell the rips'; buy and hold has been a losing strategy.

The recent rally was the result of an oversold technical condition, government action to strengthen Fannie Mae (FNM) and Freddie Mac (FRE), rules against naked short selling, better than expected earnings and a dramatic decline in oil prices. If there is one lesson to have learned from 2008, it's that good news flow does not last. The focus will return to financial weakness before we experience a seasonal fall rally. Over the remaining 15 days in August, tread carefully as the following issues resurface:

1. SEC protection against naked short selling ends now. Rumors from short sellers regarding WB, WM, LEH, GS, JPM, etc., will resume. XLF should drop back into the teens and lead the broad market lower. The SEC would like to make these changes permanent but it will be at least 2 weeks before they draft anything up. Since this protection was put in place, Bank of America (NYSE:BAC) is up 81%, Lehman (LEH) is up 41%, and J.P. Morgan (NYSE:JPM) is up 32%. What will happen during this interim period? A final assault on the banks.

2. Consumer credit card use began to fizzle in June and probably continued into July and August. Read up on the American Express (NYSE:AXP) conference call for details. Accounts 30 days past due are up 60%, and 65% of banks have raised the standards to access credit. This could be the next and last shoe to drop in the credit crisis. 2007 began the subprime mortgage meltdown, 2008 has been marked by sinking valuations of prime mortgages, and the theme of 2009 might be credit card debt.

3. J.P. Morgan issued a statement saying that trading conditions have substantially deteriorated since June. This will effect those financial leaders who have yet to be clobbered, like Goldman Sachs (NYSE:GS). Ken Heebner, an investor who reportedly trades similarly to Goldman, suffered his worst month managing the CGM Focus Fund in July as he, and probably Goldman as well, expected oil to continue up to $200 a barrel. The other dark side of institutional trading has been caused by Merrill Lynch's (MER) decision to sell their mortgage backed securities for 22 cents on the dollar to Lone Star. Now all financial firms face further write-downs on this lower than expected valuation.

4. Further write-downs means more capital raising which means shareholder dilution. It will be another year before real estate bottoms so any hope for eventual write-ups is far, far, away.

With the market now overbought, these negative financial issues present the rationale for a sell-off but it will only be for the short term. The recent market strength was a precursor to a much stronger rally later this fall. Long term, conditions have definitely improved. A stable dollar combined with declining oil will pave the way for foreign investment in US equities. This powerful money flow will provide a boost to fall seasonality that we predict will push the S&P 500 back above 1,400.

Disclosure: Short XLF