Get Ready for the Last Rally

Includes: DIA, QQQ, SKF, SPY, UYG, XLF
by: Alan Brochstein, CFA

It’s hard to believe that it has been a month since I contributed the article “No Time for Complacency: This is a Bear Market”. The article, in which I suggested that we would see a 1310-1390 range (S&P 500 had closed at 1392) over the “next few months”, has proved to be right on target thus far. I had written it to close out a temporary respite I had taken from being a bear. On January 20th, I had contributed “The Bear Turns Mildly Bullish”. Imagine how foolish I felt on the 21st, when Europe plunged (inexplicably at the time). Not only had I seemingly ruined what has been a pretty decent public record of market-timing over the past year, but it sure looked like I was going to lose a ton of dough as well! Fortunately, it all worked out well, and we recovered from very oversold conditions. Well, this article finds me feeling very similarly to how I was looking at the market back then: We are due for a rally.

A rally? Am I insane? Don’t get me wrong, I still expect another large decline later this year. The source, though, most likely won’t be the area upon which EVERYONE is focused: Financials. No, the 2nd half of the bear market will come from the profit margin erosion in other sectors. Slowing of non-U.S. economies won’t help matters either. Add in some concerns about the elections (taxes, capital gains taxes, etc.), and it could be a long, nasty summer. I digress, though. Why do I think that the range, which was tested successfully on March 4th, remains intact? As I mentioned, there is way too much focus on financials for any real surprises to come from there. It’s bad, getting worse, horrible yada yada yada. Not to minimize how significant the problems are, it’s just that we all know it now (finally). I can read all about it, but, even better, the following chart of the Financial Select Sector (NYSEARCA:XLF) tells me even more clearly – check out the volume:

Notice how much the volume has escalated? Everyone and his brother is hedging or shorting. It shows up in the leveraged ETFs out of Ultra Financials ProShares (NYSEARCA:UYG) and UltraShort Financials ProShares (NYSEARCA:SKF). As I write this, I know that in the morning we will all be hearing about Thornburg’s (TMA) demise – what a shock. They had $2 billion of equity and $32 billion of debt – talk about leverage! I thought we learned that lesson back in 1998 with LTCM.

So, here is what I expect over this month – that which will hurt the most market participants. That’s what the market likes to do! I think that not only will we revisit the levels we saw last week (1390 on the S&P 500 (NYSEARCA:SPY)), but then some. I expect a head-fake rally that will make the shorts cringe, the cash-heavy long-only guys panic and the fully invested gloat. I am talking about a print of 1415 or so. For you PowerShares QQQ (QQQQ) fans, expect 45.5 to 46 (a lower percentage than the broad market). Expect the Financials to lead and Consumer Discretionary to do very well. Maybe we get lucky and Energy doesn’t. The market is still extremely oversold despite the consolidation over the past six weeks:

Despite being pretty bearish longer-term, I remain optimistic regarding unemployment statistics. We didn’t add a lot of jobs in the expansion, and I don’t expect that the job losses will be that great during the contraction. This Friday, we get a chance to test my thesis. So, bears, be patient and bulls, be careful!

Disclosure: Long UYG