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A Week of Irrational Exuberance


                We saw a sharp rally last week in the major indices, including a nearly 60 point run in the S&P 500 index. The explanations for this sudden and sharp rally are many, but three in particular seem to stand out: 1. Meredith Whitney’s “change of heart” relative to the banks, 2. the invalidation of the head and shoulders pattern as a result of a break above the neckline at approximately 893 in the S&P, and finally, 3. better than expected earnings and economic indicators. However before we all join the stampede of the bulls, I think it is necessary to deconstruct some of these “bullish signals.”

                Let’s start with Meredith Whitney’s comments on Monday. She was bullish on the financials in a “trading call” as a result of the wave of mortgage refinance that would benefit traditional banking and corporate debt issuance that would benefit I-Banking. Meredith felt that BAC was the cheapest bank from a tangible book value perspective. She was particularly enamored with Goldman Sachs. These positive comments created a strong run in the financials on Monday and Wednesday, leaving the XLF up nearly 10% on the week. Yet Whitney was not altogether bullish on the banks, as she stated this was a trading call, and ultimately credit losses, unemployment, and a weak consumer would catch up to the banks. She believed unemployment would peak north of 13%, which banks would not be prepared to deal with.
                Technical analysis has played an increasingly larger role in the markets as of late given the erosion of confidence relative to the accuracy of any forward estimates of fundamentals. While we could argue how accurate analysts have been historically at predicting future earnings, it is fair to say that in the midst of this crisis the challenge has been harder than ever to accurately predict where the next quarter’s earnings will fall. As a result the markets are increasingly reliant on technical signals to indicate directionality. We had a strong head and shoulders formation in the markets with a left shoulder formed in May when the S&P rallied to 930 and then fell back, a head when the S&P rallied to 950 in June and fell back, and a right shoulder formed by a second rally to 930 in later June. When the S&P plunged through the neckline of the head and shoulders pattern at 893, many expected the markets to collapse to 800-850. A break back above the neckline invalidated this pattern and caused short covering and a rapid spike in the market. Contrarians would tell us this should have been expected given how many institutional investors became bearish all at once. Where we go from here technically is tough to say. Some believe that we will challenge the 950-956 level in the S&P (June highs) and if we can get a break of those levels we will rally. The more bearish side believes we are simply forming a second right shoulder or even a “double top” which will throw us back into the abyss should we not break through the aforementioned levels. Given the real fundamental concerns that still exist, and did not meaningfully change since last week, I am not of the camp that we move meaningfully above those levels and rally to 1000 or so as the bulls would have us believe. As for early next week, we are likely to see at least some degree of correction off this impulsive move to correct overbought conditions. Friday represented a doji day in the markets, which during a trend generally suggest the likelihood of at least a near-term reversal. Whether this reversal is a quick small drop to correct overbought conditions during an intact uptrend, or something more meaningful remains to be seen.
                We are also told that this rally was the result of earnings beats and better economic news. I find this contention strange when we were told by the financial press last week that “cost cutting alone will not be enough this quarter.” Earnings were a mixed bag this week, they certainly were nothing to be gleeful over, and many companies that did beat on EPS missed on revenues or experienced only tepid revenue growth. Intel and Goldman Sachs did post some good quarters, to be fair, but the rest of the major reports were not nearly as positive. Over in techland we saw Intel beat, we saw Dell warn, Xilinx miss, and Google beat but foreshadow a less rapid growth than had been seen in the past. Importantly on the industrial side we saw GE rather substantially miss on revenues. Outside of Goldman, the banks were not a positive picture, regardless of the spin to the contrary. JPMorgan posted nice results, but mostly as a result of their I-bank performance, whereas traditional banking at JPMorgan saw increasing loan loss provisions and expected consumer/commercial defaults. Interestingly we also had the new Prince of Wall Street, Jamie Diamond, warn over what would be a mess in the regional bank space. Citigroup had a beat, but only as a result of selling their Smith Barney unit to Morgan Stanley. Were it not for this one time gain, Citigroup would have been deeply in the red and more importantly Citigroup saw declines in a myriad of business groups leading this skeptic to question Citigroup’s long term sustainability. Bank of America beat earnings, but BAC also beat as a result of onetime gains including the sale of a stake in China Construction Bank. Were it not for onetime items, BAC also would have been in the red. The seemingly ever optimistic Ken Lewis from last quarter was also a bit more down to Earth on this earnings call, indicating that it would be difficult to see profits in the second half of 2009. Of course as is the case over at JPMorgan, Bank of America and Citigroup also saw rising loan loss provisions. Interestingly we also saw BB&T, the darling of the regional bank space and a bank which did pay back the TARP, miss on EPS and indicate that they did not anticipate the extent of loan losses which were experienced this quarter. Regional banks suffered as a result on Friday with the KRE down over 4%. Some more optimistic analysts would tell us that the rate of increase in these loan loss provisions appeared to be slowing, that oft touted 2nd derivative positive, but I would be highly skeptical of such optimism given the rising tide of unemployment. While Larry Kudlow might insist that “even a banker can make money with an upward sloping yield curve,” that would appear not to be the case unless that banker has strong capital markets and investment banking functions to offset losses in traditional banking.
                Over on the economic front we also had CNBC parading out the “better than expected” results. Unemployment initial and continuing claims dropped on Thursday, somewhat unexpectedly, particularly on the continuing claims side, but we also had the Department of Labor warn that these apparent better than expected results may be due to seasonality and technical factors which may result in an increase in the numbers later in the summer. Housing starts were positive as well, but this result is also somewhat suspect as this may be due to both seasonality and a rush to lock in the Obama first time home buyer credit that will expire later this year. The Philly Fed manufacturing number on the other hand was rather unexpectedly negative, bringing into question the notion of growth on the industrial side of the economy. These results may portend something positive, but we also saw “better than expected results” in May on the unemployment side, only to get an unexpectedly worse number for June unemployment. The May results sparked a rally that was quickly given back after the June unemployment read. The healthy skeptic should view these possible green shoots in that light.
                Only one week into earnings, Goldman and Intel positive earnings results, the comments of one rather noteworthy analyst, the invalidation of a technical pattern, and some possible green shots caused a sudden and sharp rally in the markets. There is ample reason to be highly skeptical of this impulsive move. Earnings quality, particularly from the banks, has not been impressive and real revenue growth has yet to be seen. Economic data has been somewhat contradictory and it is too early to call a meaningful improvement in economic conditions due to at best the possibility of 2nd derivative improvement.

Disclosure: Long FAZ