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Stock Market Strategy: Reduce Shorts Expect Equity Market Rally

The Bear is Full Right Now & May Need Time to Digest

The Grizzly we stalked in April and found in May has been devouring pathetic bulls for the last six weeks. The time may have arrived for this satiated animal to take a break.

Please refer to the chart of the NYSE Composite below for a clear picture of the six week mauling. Note the time frame of this chart is longer than previously posted NYSE Comp. charts. I’ve chosen the daily chart as opposed to the 60 min. chart because I’d like to draw your attention to the longer term trend.  Notice the black trend lines bracketing the uptrend in place since last year.  I’ve also highlighted in yellow the recent double bottom reached in the last 2 weeks. This chart clearly illustrates the easy money made on the short side is over for now. Support has been reached at the bottom of the channel and a natural bounce to work off some serious oversold conditions would not be surprising.

 nysed

I have spent a disproportionate although necessary amount of time over the last 2 1/2 months emphasizing the dangers of holding a long equity portfolio.  However, now that the market trades near the bottom of the long term channel, I feel comfortable discussing issues that may lead to higher equity prices. We are monitoring the following list of developments. Should the developments unfold favorably a market rally worthy of participation may occur:

1) As the November midterm elections draw near, a flurry of government handouts (like the story below) to spur economic growth should be expected. These handouts will be viewed favorably by the markets.

WASHINGTON (Dow Jones)–People hoping to take advantage of the first-time home buyer tax credit would have an extra three months to close their home purchases and still qualify, under a measure introduced in the U.S. Senate Thursday.

To be eligible for the tax credit, home buyers must have a valid contract by April 30, 2010 and close the transaction by June 30, 2010. The Senate measure would allow home buyers until the end of September to complete their transactions.

Senate Majority Leader Harry Reid (D.-Nev.) and Sens. Chris Dodd (D., Conn.) and Johnny Isakson (R.-Ga.) intend to offer the measure as an amendment to the jobs legislation pending in the Senate.

2) I’ll take the thought above a step further and say bad economic news may cease to drive stocks lower. Instead the market may view bad economic news as positive because the threat of a double dip recession will surely drive politicians to create new stimulus. Case in point, today’s bad economic news,  May Retail Sales -1.2% vs +0.2% Briefing.com consensus” failed to send the markets lower by the close. As I write this missive the NASD Comp. trades over 1% higher on the day.

3) Credit leads equity. This relationship continues to dominate the market place. Michael Johnson of MS Howells & Co. understands this relationship better than most. I affectionately refer to MJ as the credit Guru and his modified list of issues below demands our attention:

 Almost Time to Be Bullish

 We have provided a list of reasons as to why we are in the process of changing:

 1. If GS’s CDS credit curve steepens of so that its 1- to 5 year and 3-5 year CDS credit curves are positively sloped.

2. The re-steepening of money center bank CDS curves should begin to cause both equity and credit market volatility to decrease. Although we have only begun to see a decrease in credit market spread volatility, we expect this trend is likely to grow in the next two weeks.

3. Moody’s announcement, along with an S&P note last week, that they will not downgrade the banks and force them to confront a structural market inefficiency that could stress their business model is a huge positive.  

4. The recovery in Bank Pfd prices indicates that equity prices are likely to stabilize and begin rising again.

5. New issue market appears able to bring deals during periods of market stability

4) Financial regulation (FINREG.) by congress represents a major road block for the equity markets. Fears run high that politicians will make a bad situation worse. While I don’t disagree with these concerns, I do believe that fear often creates opportunity. Equity market participants frequently overreact. Once FINREG. is completed a major uncertainly will be lifted and uncertainty tends to be worse than reality. As time draws closer to the July 4th FINREG. deadline watch for positive market action to FINREG. developments.

Disclosure: Short GS Less than .25% of fund

About Bret Rosenthal

Interpreting the news that moves markets. Principal of RCM, LLC, and founding partner of the Fortune's Favor Family of Funds
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