Common Cents'  Instablog

The last edition of Where Do We Go from Here asked:  As the S&P approached 1000 would S&P 900 or 1100 come next?  The article concluded that S&P 900 seemed more likely to be the next stop, and an investor should raise cash and take some short positions as the S&P climbed over 1000.   Since that time, the S&P has spent all of its time well over 1000 but has not hit 1100. So this question technically remains unanswered, and perhaps the forecast from the last article was not wrong just “early”.  However, realistically the portfolio actions taken based on this past recommendation have not performed well.  It is now time to decide if those positions should be maintained or if it is time to roll into more bullish positions.  So, the next question might sound somewhat familiar. As the S&P approaches 1000, what’s next? S&P 900 or S&P1100    Too repetitive…..OK let’s refine the question a bit.  Where do we go from here? Does the S&P hits a new high (over 1080) or S&P tests its 200dma (low 900s)?  A look at a few key drivers of the market and the positive and negatives of each is shown below.

Q3  Results. – Overall impact: Neutral 

Results vs. Expectations – Positive

Will companies meet expectations this quarter? – They usually have managed analyst expectations down to a point where earnings expectations are met. There have not been a lot of negative pre-announcements so it seems likely to assume earnings will be at or slightly over expectations.  Also since GDP for the second half of the year appears to have recovered somewhat and comparisons to last year are somewhat easy in q3, it is likely revenue may be more encouraging or at least “less bad” than last quarter. 

Guidance - Negative

Collective estimates for 2010 earnings seem to be $70+.  That would be up 40% from 2090s $50+.   It does not seem like corporations have any reason to keep expectations this high.  They would be much better served trying to get these expectations down now.  Hence, I’d expect cautious guidance at best and this means downward pressure on the market.
Guidance is probably more important than results, but to be optimistic let’s call this area neutral.

Consumer – Negative

There has not been much good news in the area of jobs, housing, and confidence front lately.  That seems very unlikely to change in the next month.  So this still has to be viewed as a negative. The only potential positive spin on this situation is that the US consumer may not be as important as they once were.  Not to long ago, the US consumer was 70% of US economy and the US economy was nearly 30% of the world’s GDP.  Today, the US consumer is moving towards being only 60% of the US economy and the US economy might only be 20% of the world.  Take these factors together and the US consumer’s share of the world’s GDP is being cut nearly in half from over 20% of the world to nearly 10%.  So maybe global/emerging market consumer demand can help lift the global economy, and it is possible for mostly global S&P500 companies to show positive results without a bounce back from the US consumer.

Big Money Players – Negative

There has been much anecdotal discussion about managers having missed the rally and money on the sidelines ready to drive the market higher.  If this anecdotal description is accurate, the best way for big money players to improve their relative performance is not to drive the market higher but to drive volatility higher.  Lots of “put protection” has been taken out.  A conspiracy theorist might think that big players might try manipulating the market down, sell their puts at a profit, and then go long for a year end bounce back.    If this scenario is right, a volatile quarter could be in the cards.

Government/Politics/ Global Events – Negative

This article tries to stay away from right/left political discussion, but no matter what side of the debate an investor is on, it seems the continuing debates of Congress about health care, regulation, etc may only add uncertainty to the market in the short term. Globally, it seems possible the nuclear inspections of the “undisclosed” sites might have some twist in turns over the next weeks, and China and the rest of the world will continue to ponder a world not so US centric.  None of these factors seem positive for the US market.

Technically – Negative

 In the last run up, the S&P went to over 20% over its 200dma and had about a  50% retracement of the big loss.   A pull back to the 200 dma or 38% Fibonacci level would seem more “normal” than continuing to run well over the 200 dma.

A reader should make their own judgment on the evaluations of these drivers, but based on  the positives and negatives as shown above,  the answer to where do we go from here seems obvious. S&P 920 here we come!  It is unlikely that will be achieved via a straight 10% free fall from here, but rather a step down function giving adroit traders a chance to make some short term money on the way down.  However, the best overall strategy for the next few weeks seems to be to continue to raise cash and get short as opportunities present themselves.   If/when the S&P gets within shouting distance of 920 it will be time to re-evaluate the next move.  However, at this time, the next move from 920 would appear to be up. So get a good wish list together.  Perhaps some stocks might be on sale for early holiday shopping!

The June edition of Where Do We Go from Here suggested that the equities market would remain range bound in June.  Specifically, last month's edition suggested that when the S&P went over its 200 dma it was time to either lighten on equity positions or hedge positions, perhaps with covered calls.  This approach worked well in June but….where do we go from here? 

To state the obvious, the market can stay in the current range, break out higher, or break out lower. Is July the time for it to break out? Let's look at the case often put forth for each scenario, which scenarios seems most probably, and what trading actions might be prudent to take now. 

Scenario 1 - Market stays range bound - Fundamentally, the market may have priced in a second half of year economic recovery, and needs to wait for confirmation or repudiation of this thesis over the coming months before breaking out of the range.  Technically, the market has strong, nearby support (875) and resistance levels (950).  Perhaps most importantly, key market participants could have reached an exhaustion point after the volatility of the past year and psychologically they will be driven to create a "pause that refreshes".  The recent low volume in the markets may be an indication that the summer doldrums have arrived.    

Scenario 2 - Break out higher- Earnings season is beginning. Last quarter the market rose as earnings season unfolded and a realization that "the next great depression" was not upon us and a view that "things are getting less bad" started to take shape.  Record levels of government stimulus are hitting the economy.  A few good early earnings reports could stoke the animal instincts of market participants and once again push the market higher.  Also, if evidence emerges that macro level green shoots are blossoming it could fuel an upside break out.  For example, some recent data seems to indicate the housing market may be bottoming, and it is possible that this summer could indeed mark the bottom of the housing market.  Many investors would take a housing bottom as a signal to more aggressively enter the market and thereby fuel upward momentum.    

Scenario 3 - Break out lower - As mentioned above, last quarter's earning sparked the market to go higher because they weren't as bad as some expectations.  This quarter, it is unlikely that "less bad" earnings would be sufficient to propel the market higher.  If earnings just meet expectations and companies comments regarding the future remain cautious it will likely prompt fundamental analysts to trot out the analysis that based on 2009 S&P earnings estimates of $50 and a 10-15 multiple means of an overvalued market.  Technically a market fall to the 750-800 in the next few months would create a classic reverse head and shoulder pattern.  Psychologically, with no end in the rise in unemployment in site, it seems consumers continue to act cautiously, de-lever and save.  Lastly, recent international headlines emanating from places like Iran, North Korea, and Nigeria have been disturbing.  The potential escalation of global tensions into some significant ad news events represents a further downside risk. 

The scenario which seems to be most commonly favored among the "talking heads" is for the market to continue to trade in the 875-950 range.  This could indeed be the case. If so that would mean an investor would probably not be adversely affected by maintaining their neutral allocation to equities and perhaps try to make some small training gains. However, contrarians might find the consensus opinion of a range bound market disturbing, and common sense says the market will not remain in its current range forever. July may or may not be the time for a market break out, but common sense also says that an investor should be prepared for the next move.

If the market does breakout in July, the next short-term direction for the market is likely lower (below S&P 850).  Key reasons include:

-  Psychologically it seems active market participants are too worn out to push the market on good news, but the press and public seem ready to continue to beat the drum of worry and fear which could easily take things lower in the short-term.

- Fundamentally - even if earnings are "as expected" or even meet some higher whisper number, stock multiples will remain historically high.  Also, given a lot of scrutiny of corporate behavior over the past months, it will be risky for corporations to talk overly aggressively and optimistically about the future on their conference calls.

- Technically - The market recently broke above the often watched 200dma.  The 200dma will very likely continue to fall for awhile.  It seems unlikely the market would move significantly above the 200dma quickly. It may be more likely to bounce below the 200 dma before a major upward move.  

If the market does break lower, is this the return of the depression scenario and time to sell stocks?  Or ….is there is a high probability that if the market breaks lower it won't stay down for too long.  Many factors such as traditional business cycles, unprecedented, global government stimulus, and the continuing march of consumers in emerging markets toward a middle class life style, are strong, concrete factors to make a down move somewhat temporary. Hence, if the market breaks out lower, an investor should be ready to increase their long positions in the market.  Specifically, they should have a "wish list" prepared and ready to be ready to act.  Items on a wish list might include:  Early cycle industrials, core technology, infrastructure, Asian markets, and an overall bias towards smaller cap stocks.  Perhaps buying some LEAPS on select positions could be a more risky but appropriate strategy.

If the market unexpectedly breaks out to higher levels in July, it would be difficult to see what further catalysts exist to keep it moving higher through out the year.  That means if the S&P goes over 1000 it would be time to raise cash and even increase short positions in a scaled manner.  A list of areas in which to consider lighten up positions based on a upward break out would include energy, financials, and materials/commodities.

In conclusion, the market could stay range bound in July, but common sense says a break out of the range has to occur sometime and it could be relatively soon.  Evidences seem to lean towards the next move being down to near S&P 800.  Most importantly, no matter if the break out occurs in July or not it is time for investors to be mentally and tactically prepared to act for whatever break of the trading range comes next.

Disclosure: Long SPY