We've Bounced Too High, Too Fast: Time to Short Financials

Includes: FAZ, XLF
by: Trading Alpha

Are we likely to soon retest March lows? History very clearly says yes. There are some other reasons in support of a retest.

This 20%+ run in equities in less than a month was way too easy and way too quick. Gains of 40 to 100% in certain sectors and stocks occurred without genuinely good news. The run was a reaction to oversold conditions - not a real recovery - and was probably based on short covering and a slanted view of bad news (or "not so bad news" as people are now labeling anything a smidge above horrendous). Consider the gains you may be sitting on currently - were you lucky or good?

Our global momentum is in too much of a downward spiral for an economic bottom to be within several months. It is commonly recognized a market tends to bottom six months or so before the economy bottoms (2002 - 2003 was a recent exception to this that could play out again with a U or L bottom).

So let's test your economic intuition. Based on the current trajectory and momentum of the U.S. economy including job losses, housing price declines and credit evaporation do you see the rate of decline starting to slow in a material way? Do you see it at your place or work? You would need to for a bottom to be around the corner.

Government stimulus is not going to kick-in with a G force this year or in any future year. Considering it will probably take three to five months for the rate of decent to slow and flatten out before we bottom, we would need to feel and clearly see the pace be slowing right now. I don’t see it. The vast majority of the key stats are in a free fall. The fact the pace of decline is not increasing is not good news. Even a object falling out of a plane hits a max speed. It can't go any faster at some point. Commenting that the object's fall has stabilized at a 120 MPH clip towards earth is not good news or even "not so bad news". If you still feel we are slowing our rate of decent then ask yourself besides hope, what can you point to that caused this?

Are the economic fixes in place? Consider what is going on in Washington D.C. between Congress and the Administration. This is not a garden variety recession but a unique strain of great recession we have never seen before. We are throwing trillions at it and every have a scheme every other week as a cure. Yes we avoided a market meltdown last fall but has anything else really taken hold to get out credit markets working again? How about the banks? How about consumers? Are consumers going to bounce back to the overspending ways of the past two decades or will they likely permanently adjust to a more sensible way of spending that will put a drag on GDP over several years? Without the economic fixes in place we can hardly make a speedy bottom.

Bear markets retest before a new bull market begins. Take a look at history from 1950 on, as provided in this handy link, that allows for an easy examination of past bear markets.

There are nine completed bear or near-bear markets presented on this site. 1990 is a near bear so I have excluded it from my analysis.

Of the remaining eight bear markets, the final low was retested in seven of the eight - that's an 88% chance. The retest took place about 10 weeks out from the final bottom so in our case, this would be around 5/20/09 if the timing held true to the average but retests could take three or four months.

Only one bear market did not retest and that was the 1980 - 1982 recession. It was fairly mild with stocks not spending much time down more than 20%. Depending on how one defines a retest, some might say the lows of March 1982 were retested. I thought a new low of 3.5% briefly established in August 1982 was more than a retest so that is how I called it. If you see it differently then we have rested sight of eight bear markets since 1950.

All the other retests were where the market got close to the final bottom - within a few percent but did not actually touch the old low with one exception in 1966 where it barely crossed it by about 1.4% (1966). I considered 1966 a retest and not a new low.

I also examined just the big bear markets - markets that declined by 35% or more to see what the results might be given this a severe bear market. Here is what I found:

Three Big bears (68, 73 and 00)

  • Number of lows - 4
  • Percentage of final lows retested - 100%
  • Time to retest final lows - 2 months (turning point is about 1 month out - from 3/6/09, that would be today)

It is tough to find predictable patterns but this one is very clear.

Could we establish a new low? Certainly. By my count we have already had 5 lows in this bear market so 6 lows would be unusual but possible.

At this point it seems highly likely we will at least retest the March lows. As I wrote in this recent article, "Last week the markets partied...," I suspect we have already begun our trip to retest the lows and Q1 earnings will very likely assist the process. Hopefully we will see the rate of decent start to slow over the next several months and for some of the fixes to take hold for without these two things, a final bottom will not be close by.

Shorting financials (NYSEARCA:XLF), the sector that has had the greatest gains over the last month, is how I'm playing this.

Disclosure: The author is short financials and long oil.