Week In Review

Week In Review
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By Bill Cara | 26 July 2010

Mixed signals. Traders are taking on more risk in the short term and yet they fear the distinct possibility of a massive shake-out to come this fall. A week ago we referred to the possibility of a 'wall of worry' filled summer rally. This week we will be looking for clues from bonds, the Yen and Gold.

Now and then I do get it right. A look back to Week In Review 17, which was 13 weeks (1 Qtr) ago, the date was April 25, which was the absolute peak of the market cycle at that time. After you look at the next chart, which clearly shows the destruction, read some of the many words of 'heads-up' I published that weekend.


Click Here, or on the image, to see a larger, undistorted image.

May and June was a terrible time for the Bulls. Here's what I wrote in the days leading up to that late April sell-off:

[From the Wrap-up of WIR 17 April 25, 2010] "I don't know the biggest problem that faces the equity market today, but I can see that something big is looming. I have a theory about fear. Under stress, people withdraw. In capital markets they tend to sell risk, which they perceive is foreign, and buy local. "Americans and US-based bankers are the world's biggest players in the capital markets. So, when stressed the most, they tend to buy the S&P 500 and sell foreign stocks. When foreign stocks are sold and money repatriated, there is a stronger Dollar. That started just before year-end. Click Here, or on the image, to see a larger, undistorted image. "But look at this chart of the S&P 500 (SPY) versus the Global 100 (IOO), which includes some stocks in the S&P 500 and some in the S&P 700 (non-US-based mega cap stocks). The comparative relative strength RSI-7 Weekly index of SPY:IOO has skyrocketed from under 30 in 4Q2009 to the nose-bleed extreme of 87.15 today. Click Here, or on the image, to see a larger, undistorted image. "Now look again at the chart above to see what happened in every period of great anxiety. In early 2008, Bear Stearns became a problem to the credit ring of banks. Their leverage had grown to greater than 35X, and that was assuming the assets they held were fully saleable, which was not the case. Leading to the Bear Stearns bankruptcy in March 2008, this SPY:IOO rose to an RSI-7W of about 78 from about 20 in 4Q2007. "In July 2008, the SPY:IOO RSI-7W had fallen to a low of about 33. Then, in response to the sudden implosion of Lehman Brothers in September, that index skyrocketed to a peak of 80 in Sept-Oct. After other banks moved quickly to take over the Lehman assets and liabilities, the RSI-7W quickly dropped back under 30. But, in January 2009, the economic crisis hit the world's financial system in full force. "Banks[[— fearful of the solvency of lending banks and other parties—: normxxx]] simply stopped lending money [[ie, the interbank and 'commercial paper' markets "froze": normxxx]], consumption seized up, production shut down, and unemployment soared around the world. So, for 1Q2009, the G-20 decided to flood the world with money, causing the RSI-7W for SPY-IOO to plunge again from almost 70 to just a tad under 30, and it has stayed in the 30-40 range mostly until the latter part of 4Q2009. Now look at that RSI-7W for 2010 (over 70 and up to this week's extreme of 87.15) and look at the SPY:IOO comparative index, which is the highest in years at 1.982. "US-based shareholders and money managers then are buying American, which basically is what the S&P 500 is, and the most American of the US sectors are the Financials, Consumer Discretionary and Industrials. That's because the biggest companies in Energy, Basic Materials, Consumer Staples, and Healthcare have a larger non-American base of stakeholders, relatively speaking. So, ahead of a harsh winter, Americans start squirreling away their "nuts" if you will, and as I say, that happens to be Financials, Consumer Discretionary and Industrials. Click Here, or on the image, to see a larger, undistorted image. "Now look at the market sector performance since January 1 this year [1Q 2010]. XLF +14.2%, XLY +18.9% and XLI +17.0%. I say something is about to break here, taking the S&P down faster than the IOO, both of them probably tumbling together as happened for several months after the Lehman collapse. Something to think about this weekend."

That was late-April, and the market did sell off severely. Now I see something quite different. Yes, there are mixed signals, but everything is telling me that the first move is up. As you know, a couple weeks ago I opined that the market was oversold, and ready to rally.

Then, a week ago in this space, following a treacherous session on the closing Friday, I further suggested that traders were too negative. I opined: "Yes, I have opined that we'll see 880 on the S&P 500 this year, but not before a Summer Rally, one that includes Crude Oil prices in the 80's and the $GOLD price over $1350. You see; I'm counting on the Fed, ECB, Bank of Canada, and Bank of Japan to start printing money. I hear it comes on trees. Then, perhaps when people realize it doesn't, that's when I think we'll see 880 on the S&P."

This week, with the S&P 500 up +3.6%, the Bulls have had what I believe may be a counter-trend rally inspired by short-covering— remember, a week ago the Bulls were in a state of near panic. Also, after hitting a high for the week of $79.60, Crude Oil has lifted +3.6% to $79. Due to the confidence shown by Europeans in their banking system following the release of the 'stress test' results— ergo the release of the safe-haven gold trade— $GOLD at $1189 is lagging, but has shown signs of lifting along with the higher prices of equities and commodities. So, the market has unfolded pretty much as I presumed.

Summer rally? How long and how high? Hmm; that's the thing about trading— traders get a feeling based on the indicators, which is why I had an unusually strong negative feeling back on April 25. But we know from experience there are no absolutes, and that knowledge causes us to trade the prices we see. As for the market scenario I have painted for the near future, I think there will be higher prices, but possibly not for long, and not significantly higher.

I think we'll see a lot of churn in the market as the major capital pools offload their inventory of stocks they don't feel are well positioned for the central bank tightening and higher interest rates to come. At some point, possibly in September or October, the Fed will shut down their money printing exercise so as to not impact the election results on November 2. That 'de facto tightening' plus the increased selling and lack of new buyers would likely cause a significant sell-off. My crystal ball is flashing S&P 950 and then 880, still.

You see, I don't think the bad loans held by investors [[banks?: normxxx]] have been written down to the extent needed to bring risk in line with the extremely low interest rates set by central bankers and bond yields set by the market. [[HELOCs— which are now almost all worthless— have hardly been written off at all!: normxxx]] Moreover, I think equity prices are too high relative to prospects a year out for sustainable profitability; hence current prices, in my mind, exceed 'fair value'.

But here's the second part of the story. As and when 'normal' trading volumes return to capital markets, I think these factors will return to balance, and the equity market will have returned to its status as a functional price discovery mechanism. Then the market will be ready for a very significant Bull phase. [[Which could mean a very significant rise from the October/November low to a peak early next year followed, perhaps, by another downdraft in April-May-June.: normxxx]]

We're not there yet. The process of deleveraging is probably not yet complete, as I see it. Lower equity prices and higher bond yields are required to set it up. Either that or else we'll soon see more inflation in equity and commodity prices, which will lead to economic stagflation, which would not be a good thing for the higher levels of employment and spending needed to sustain satisfactory economic growth plus that Bull market I foresee.

M O R E. . .