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Prepare for a sell-off through summer
By Barry Ritholtz 3/31/2005
On Monday morning, I warned clients to use any lift to sell equities. CNBC reported on the call in the afternoon, and many readers have asked for a more detailed explanation.
Last week the market became so oversold that a corrective bounce was due. We saw that move begin in Monday's rally. But don't get too excited yet: I expect this bounce to last a week or so -- two at most -- before the markets start heading south again in a sell-off that I expect to last until early summer, and bring the Dow down to the 8,800 to 9,000 level.
As such, I have been advising clients to use any lift as an opportunity to exit most of their long positions. In particular, I have been exhorting managers to sell cyclical, rate-sensitive and high-beta holdings.
I have aggressively sold equities, and I am now about 50% cash. I expect to be in even more cash by next week. If some of the major oils come down enough, I will selectively add to those positions. I'd like to see InterOil (IOC, news, msgs) at $32-$34 prior to re-entry. I'm also looking for an advantageous entry into gold, including the streetTracks Gold Trust (GLD, news, msgs) -- anywhere between $40-$43. Finally, I am looking for the recent rate rally to sputter out. I am considering buying the iShares Lehman 20-Year-Plus Treasury Bond Fund (TLT). An entry between $84-$88 is technically warranted and yields 4.6%. It's as good a place to hide as any.
Individual investors should also take advantage of any better prices to aggressively sell positions that meet those qualifications. I'd also dump individual stocks that have not been behaving well. And as I wrote last week, it is crucial for individual investors to eliminate long margin exposure.
Down near 8,800-9,000, I would become a buyer again, depending upon circumstances and conditions at that time.
Don't fight the rally
Several factors point to a modest but short-lived rally.
From a sentiment perspective, the bulls have gotten scared. AAII now shows bulls at 23%, down from 45% two weeks ago; bears measure 41.9%, a big move up from 24.8% over the same time period. That's simply too bearish, short term.
Other measures also suggest that the market has reached a moderately oversold level. The NYSE oversold indicator, where any reading below -50 is significant, measured 58.12. So, too, the NYSE McClellan oscillator reads oversold at -256; anything below -200 is significant there.
Despite all these oversold signals, I remain concerned about the ongoing deterioration in both the internals and the macro environment. The advance/decline line continues to soften, something that should not be occurring as the market rallies, and the Nasdaq 52-week highs/lows also has flipped negative. This is another sign of deteriorating technicals.
Longer-term trendlines also have broken and upside moves have been unable to sustain their gains. This is a clear sign that momentum is fading.
The economic environment is weakening
Now add problems in the macroeconomic environment to the technical deterioration. GDP has softened.
Personal income is not keeping up with price increases, just as consumers have lost the ability to do cash-out refinanced mortgages. (If you are looking for a reason as to why mutual fund flows have been so light, that's as good as any.) Money supply has also been throttled back by the Fed, and the yield curve is flattening. | Market Commentary Bearish | This rally should be used to sell long positions ahead of a brutal decline into summer.
The market's technicals are deteriorating and macroeconomic factors will exacerbate the selling.
The decline will be slow and steady, culminating around 8,800 to 9,000 on the Dow. |
We now have an oversold market that has not been able to rally on positive news. This reveals an underlying weakness, and possibly a decreasing appetite for equities. The market's complete inability to respond well to the major upside revision from General Electric (GE, news, msgs) last week suggests a market lacking leadership.
If anything, the market's recent response to positive news reflects a new sentiment shift. A few months ago, economic reports were getting spun positively. Good GDP or employment data meant the economy was expanding; bad data implied that the Fed could stay accommodative and measured for a longer time. That sentiment is now shifting.
Bad data mean the economy is weak, while strong data will only hasten an eventual 50-basis point hike. For further clarification of this sentiment shift, I expect the market reaction to Friday's employment report to be revealing. Is good news bad, or is good news good? We'll find out soon enough.
Lastly, look at what's been occurring in the dollar, gold and oil. The countertrend rallies in these areas are of a short-term, corrective nature. They can run long enough to sucker in traders, but once they resume their prior trends -- dollar down, oil and gold up -- many players will get caught leaning the wrong way. They will be desperate to stop the pain, and that will exacerbate the selling in equities.
Plan the painful path
So far, the high for the first half of the year was put into place on March 7, with the S&P 500 ($INX) closing at 1,229 and the Dow at 10,984. I suspect that we will not be able to power through those levels, a good 5% higher from yesterday's close. I further suspect a lot of people have been watching those numbers. If we fail there (or lower), here's how I see a likely scenario playing out.
The market won't simply collapse. That would be way too easy. Rather, we could get sandpapered to death, sliding a few days in a row, then rallying a day, on and on until the summer.
By then, there should be enough disgusted investors that the markets can put in a solid, extremely oversold low. That sets up the markets to claw their way back to near break-even by year's end. By December, we should more or less be back to where we are today. Depending upon the circumstances at that time, that may be a particularly advantageous entry point for shorting the markets.
Proving or disproving the thesis
Every time I make a forecast or market call, I start with the presumption that I will be wrong. Then, I begin looking for signs that will validate or repudiate the call. So what would prove this market forecast call false? There are several ways that can happen: - First, the markets can sell off faster, and get more deeply oversold at this point than I expect. That would set up a longer, stronger rally then I am presently contemplating.
- Second, the markets could break out to the upside, rallying over their March 7 highs on strong volume. Any breakout over the March highs makes this call absolutely wrong. I doubt we would even get a "head-fake breakout." A closing price over the March highs would force me to redeploy capital.
- Lastly, we could see a series of improving economic data showing inflation-free growth. I don't mean the misleading headlines of unemployment or home sales; I mean honest-to-goodness nonmanipulated growth.
Barring these factors, I expect the market to make a painful descent into the summer and as mentioned previously, I expect the year to finish flat to negative. Consistent with my bear sandwich thesis , a second-half rally will set up an opportunity to get aggressively short into 2006.
Lastly, while everyone suddenly discovered last week that (horror!) producer and consumer prices have been going up, I am becoming increasingly concerned about the macro impact of derivatives. From Fannie Mae (FNM, news, msgs) to American International Group (AIG, news, msgs) to GE to Berkshire Hathaway (BRK.A, news, msgs), all too many U.S. companies have turned into heavily camouflaged, leveraged hedge funds. Skipping over the esoteric details, I suspect this too, will end badly.
This is an intermediate top call. Take advantage of higher prices, as I expect this rally will run out of steam in early April at the latest. The market risk is a sell-off into the summer. Position yourself appropriately this week.
Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to barry.ritholtz@thestreet.com. Click here to read our conflicts and disclosure policy.
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