Short versus Long Term: The Topping Process at Work

Thursday, August 03, 2006 | 03:05 PM

NOTE:  This Trading alert was originally posted at Ritholtz Research & Analytics on Thu 8/3/2006 3:05 PM EDT; An email went out to subscribers alerting them shortly there after.

This is posted here not as investing advice, but rather as an example of a trading call for potential subscribers. We expect to post future advisories in a similar manner -- after the call, but in the correct chronological location on the blog.

~~~


One of the hardest things about analyzing the markets is separating the short term outlook from the longer term situation. There are occasions when they are diametrically opposed to each other.

This is one of those times.

I suspect it is because the market is now beginning to trace out its final top that we are seeing such ambiguous and conflicting signals.

Short term, the markets may react to several developments positively. One of the reasons I did not suggest getting short last week was the risk I see to the upside.

Longer term, I remain more convinced than ever that the economy is now on rocky footing. I put the possibility of a recession by next year somewhere around ~65%. Housing, which has been the prime driver of this economy, has lost its momentum. Job creation has slipped, GDP is softening, durable goods data unimpressive.

For the rest of this year (Q3 and Q4), GDP slides down to the 1 - 2.5% range; I also expect Q3 earnings period to be very problematic. Next year, we expect growth at 0 - 2%.  That means the longer term call for the stock market is downwards. If I am correct about the GDP, a 20-30% correction in the S&P over the next 12 months is not that hard to imagine. This remains our long term concern.  The recent out-performance by defensive sectors – Utilities, Consumer Staples and Health Care – imply markets are perceiving the same weakness.

Over the short term, however, the market seems to be firming up somewhat.
Although there is lots of volatility, macro bad news hasn't been hurting the market as much as you might imagine. Sentiment measures now show a modest level of bears, which can often support a rally. There has also been a modest improvement in the technicals. When we look at the charts, we see that SPX has sold off from its May5th top, made a bottom on June 13, and almost retested those lows July 17th. Today, it cleared the 1281 level, which suggests a possible retest of the prior highs at 1325. Volume remains weak, but after all, it is the dog days of summer.

But aside from these other factors, the biggest risk to the upside are the whirling dervishes I call the "One & Done" crowd. This is a large group of fund managers and pundits who have whipped themselves into a frenzy on the prospect of a pause by the Fed.  Their thinking goes like this: Once the Fed is out of the way, markets are free to rally. 

Now, we know that the Fed stopping often bodes ill for equities: If we go back to 1929, 71% of the time the SPX was lower six months after the last rate increase; it was lower 64% of the time 12 months later. We expect this cycle to play the same – lower 6 and 12 months later.

But the "One & Done" crowd is hearing none of that. I believe they have the ability to whip the markets up for a few percentage point gains between now and late August. If we see a weak NFP number tomorrow, that may very well be the final nail in the rate hiking cycle. At the very least, I expect to hear the Fed change its tune when I comes to their statement, which I expect will include a shift in the risks being weighted more heavily towards a slowdown.

So the "One & Done" crowd will get their wish: The Fed will either stop or hike a ¼ point but change their language significantly. This may very well release the animal spirits, and could take the markets higher.

That will leave the markets free to enter the final phase of the topping process.

Those of you who are nimble traders may want to scale into long index positions in advance of NFP tomorrow, and add to these positions over the next few days. If you are short, you may want to cover.

But remember – this is a trade, not an investment, and I very much doubt it lasts longer than a month.

Thursday, August 03, 2006 | 03:05 PM | Permalink | Comments (1) | TrackBack (0)
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Comments

Interesting action on today's rally. Why can't the bulls close the S&P above that resistance level? Perhaps we need a Fed pause to push it over. I went long yesterday at the close, but got greedy and wiped out around noon.

Posted by: ch | Aug 4, 2006 6:10:02 PM

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