Protect Your Portfolio: Here Comes the Squeeze

Get ready.

Earlier this month, I commented that the latest stock market rally was a load of nonsense. For one thing, it was kicked off by a massive short squeeze—the SEC’s alleged “new” policy about banning naked short-selling in financial stocks—not actual bulls. If you’re looking for a sustainable bull market, you need actual buyers, not guys who are buying stocks to cover their shorts.

Then, of course, came the Fannie Mae (FNM) and Freddie Mac (FRE) intervention or “intervention to be.” Hank Paulson set a world record for quickest turnaround on a the quasi-government mortgage lenders, first stating there would be no bailout in mid-July, then asking Congress for a blank check to bail out both lenders only a few weeks later. The decision earned him the nickname Super Hank. I think Two Face would be a better moniker.

To be blunt, rallies need more fuel than short squeezes and government interventions if they are to become full blown bull markets. As the below chart shows, this latest rally was even weaker than the one following the Bear Stearns intervention—that rally lasted a full two months, this latest looks to have peaked in one month’s time. And now the market is showing some truly ominous signs.

As you can see, the S&P 500 has been rejected by its 55-day moving average (DMA) twice in August. If we were going to see a sustained rally, the market should have broken above its 55-DMA with little effort like it did back in April.

Even worse, the S&P 500 is now forming a rising wedge consolidation pattern between its 55-DMA and 28-DMA. Indeed, it is only hanging on to its downward support line — the 28-DMA — by a thread. These patterns typically break to the downside. Given the action we saw on Monday and Tuesday, it looks like it’s only a matter of time before the squeeze is breached. And it looks like it will be breached downward.

If you think the carnage of the last year is near over, think again. When you remove the two most profitable sectors — Energy and Materials — and the sector with the biggest losses — Financials — from the mix, the S&P 500 is only down about 5% from its peak. Put another way, the losses we’ve seen so far have largely come from financial firms.

But this is beginning to change, BIG TIME.

Retail sales fell 0.1% in July, the first drop since last February. And this was AFTER the US government paid out over $100 billion in Stimulus Checks! Sales at restaurants, sporting goods shops, auto manufacturers and other sectors all fell. Those companies that have managed to produce profit increases — Hershey’s — are doing so through via price hikes not increased demand.

And yet Wall Street still believes we’ll get through this without US corporations losing money.

As of August 5, analysts expected total S&P 500 earnings for 2008 to only fall 0.3% from those of 2007. Let me rephrase that … analysts expect that companies in the S&P 500 will see profits break even from those of last year during the worst housing bust, recession, and inflationary conditions we’ve seen in 30+ years.

So we’ve got un-provable bullishness — yes, I count a breakeven forecast for corporate profits bullish, given the mountains of evidence that things are getting much worse in the US economy — and a stock market rally that was kicked off by government intervention.

This will not end well.

I think the market is headed for a very ugly fall in the next month. I wouldn’t be surprised to see the S&P 500 fall to test and possibly even break through its July lows. I highly recommend establishing some shorts or taking profits. Things are about to get nasty.

Comments

[John Apodaca:]

Wow! Let the good times roll Mr. Sunshine!

All kidding aside, I agree. We never got that capitulation panic in mid July.

2008 Aug 20 05:05 PM

[Jimmy Lathrop:]

The problem we have is when the financials hit a certain low, the black box trading takes over and the market is flooded with buy orders. SKF shot up to 137 today at 1030 and by close it was at 129, 2 dollars off of yesterdays close. There is no rhyme or reason, it is just low volatility and automated trading. Until we get more live bodies on the floor and behind their monitors, these markets are going to be trapped in trading ranges.

2008 Aug 20 05:36 PM

[Jimmy Lathrop:]

Correction - not low volatility, low volume.

2008 Aug 20 05:36 PM

[The Realist:]

These short term swing are just noise. I believe as an investor you must focus on the fundamentals and they are not good. When I look at the S&P at 1300 last week my first thought was, where can this go from here. How could it go up? Was it going to go up another 150 points to just under its high from last October? With all the bad news that has come out and the tremendous losses in the banking sector should this index be anywhere near its high? And don't get me started about retail. Every single retailer beats their own made up numbers by 2 cents then guides down and the stocks traded up.

These rallies are just bear market bounces. We had a two month downswing from May-July, almost every day was down, the chart is almost sickening. A bounce had to come and the Fed and Treasury helped it. But the next downswing has started. The last downswing at the end of May just so happened to start the Monday after options expiration day. Wow, this Monday happened to be the Monday after expiration day as well. Just a coincidence?

Did anyone check the put prices for the banks when they were running up? The premiums were insane. WB when it was trading near $20 had $15 Oct puts trading over $2. The market makers were basically saying that they did not care where the current price of the stocks were at.

2008 Aug 20 06:36 PM

[investor88:]

Good quality analysis here by Graham. The outlook in the few months ahead has to be negative, traders and fundamentalists will find this article useful background information.

2008 Aug 20 10:37 PM

[inthemoney:]

I completely agree. I couldn't beleive my eyes when I saw retailers rally 10-20% last week. It was clearly a short squeeze, but all the same. It is retailers time now and industrials , if emerging countries slow down.

2008 Aug 20 11:54 PM

[Fish Gone Bad:]

I really liked this article. Thank you.

On April 8, 2007: Bucky the cat (in the cartoon strip Get Fuzzy) said, "Ignorance doesn't make stuff not exist".

It is truly amazing how people think that the US financial crisis has bottomed, or we are half way through it. Time to make some money.

Clark Jenkins
FishGoneBad.com

2008 Aug 21 12:36 AM

[bearfund:]

One thing you did not mention was the thing that scares me most about stocks: VIX. It's low. Real low, for a bear market. Investors are not protecting themselves with options; they are complacent. Complacency, a rising wedge on light volume in a weak bear market rally, and horrible fundamentals that have been largely ignored are a bad, bad mix. A crash is not out of the question.

2008 Aug 21 12:58 AM

[bbzz24:]

bearfund,
when volume is light that means the price is not quite fair although still used for daily marks due to regulatory requirements.
when vultures become active things will look like bottomed: simply because this is the point where all cash players can get adequate returns without leverage.

2008 Aug 21 05:15 AM

[fxtrader07:]

hm, the tricky part of course is, WHAT to short now to protect a portfolio. financials may sink further, but i believe shorting financials is becoming a low reward-high risk position, increasingly. the whole s&P? well, not so fast! quite a lot of energy and financials make up the index. energy and commodity-related stocks have been beaten up and some absolutely hammered over the past weeks. so enertgy and financials may put a rather solid floor under the index. retailers, on the other hand, need to be examined 1by 1. wmt has obviously profited and will continue to profit from the economic climate. at the very least, they will not see a dramatic deterioration in their profits. amzn, on the other hand might get a rude awakening, in part thanks to the diminishing gains from dollar-depereciation. so amzn would be my favourite retailer short as it will get hurt by global slowdown and carries still insane valuations. that brings me to the nasdaq and tech stocks. i think they will be the most vulnerable as most of them rely on growth to justify their p/Es - and this growth may fall apart. but here again, the sectors ought to be taken one by one. semiconductors, for instance, look rather cheap

2008 Aug 21 05:37 AM

[notsosmart:]

you want protection?dont believe anybody abut anything.they all have an agenda. think for yourself.in this fast moving world much can happen & nobody really knows anything.

2008 Aug 21 10:31 AM

[tipalia:]

I completely agree with notsosmart today.I don t always agree with him but he has it right when he said « ...nobody really knows anything.»
No disclosure at the end of this article,is he shorting the markert.I would not be surprised that s what he is doing right now.Then maybe not in this case accept my apology.

2008 Aug 21 12:51 PM