Sunday, March 11, 2007

Dead cat bounce or a bottom?

`Tis the question on many people’s mind, after one of the most horrific weeks in years and apparent stabilization this past week. A number of respected sources argue from history and market internals that what happened on Feb. 27 was not the start of a bear market. For example, Chris Pulplava from FinancialSense quotes the venerable Paul Desmond from Lowry’s:

In the present case, there was no evidence of a prolonged deterioration of investor psychology. Past experience shows that 90% Downside Days occurring near the market highs with no warning signs of a major market top, are typically part of short term corrections, and thus eventually provide an opportunity to buy stocks with strong Power Rating patterns at the time of the next short term buy-signals, for a resumption of the primary market advance.

That may indeed be the case. But it is also undeniable that “risk” has been again thrust into the forefront of investor’s consciousness. While many a market pundit has been chanting “the fundamentals have not changed”, a slew of the latest reports paint a different picture:

  • Durable goods order down 7.8%
  • Consumer confidence down
  • Retail sales weak
  • The February non-farm payroll gain of 97k as well as a reduction in the unemployment rate to 4.5% was well received by the market. However, even a little digging reveal some worrying
    • In order to keep up with population growth, approximately 150k jobs per month need to be created. This is well ahead of the February number. Further more, gain in February was entirely due to contribution from the birth/death model totaling 118k.
    • The reduction in unployment rate was due to the reduction in the workforce participation rate – in February, the civilian labor force is deemed to have shrunk by 190k.
    • Bleeding in goods-producing sectors of construction and manufacturing continues, as is the gains in service sectors. Construction jobs decreased by 62k. CalculatedRisk has predicted loss of 400-600k real estate related jobs this year (construction + other RE services). We seem well on the way.
    • Government jobs jumped by 39k last month, 40% of the headline increase.

Just a little digression on the topic of conversion of manufacturing jobs into lower paying service jobs: Optimists have cited US’s successful transition from an agriculture economy to a manufacturing economy as a reason not to worry. Peter Schiff, in this weekend’s interview with Jim Pulplava, very eloquently picked that argument apart by pointing out that the US did not then, nor now suffer from a trade deficit in agricultural products, but the same cannot be said about the manufacturing sector. The loss of manufacturing jobs is a part of the global imbalance that doesn’t have any easy fixes. I won’t even pretend to know how it will be resolved, but in almost all scenarios I see some reduction in American’s consumption level and depreciation of the US dollar.

No back to the market at hand. Arguably, the “grey Tuesday” started with emerging markets. Below is a chart of EEM. Although the stochastics are bouncing from oversold levels, it seemed to have stalled in the past two days as it approached the 50 dma.

EEM represents one of the stronger indices. QQQQ ($NDX)’s behavior is more common. It could be construed as forming a bear flag which upon breaking down would herald a date with the $40 level. I didn’t draw the Fibonacci levels, but for QQQQ and others the 38.2% retracement level had been reached; for EEM, the 61.8% level. Now, the market doesn’t have to follow just because I drew a couple of lines on the chart. Currently all indices are showing positive momentum from oversold levels so I’m not aggressively shorting here. At the same time, any break from here would be a nice entry point.

So rather than answering the question posed in the title, let me again talk about the positions I’ve taken. Aside from some core holdings (mostly PMs and energy), I have moved significant parts of my portfolio into hedged equity (HSGFX) and high quality bond funds. I hold no short positions currently. The violent responses in the subprime sector amazed me -- not so much at the precipitous price drops, but at the timing on a philosophical level. For weeks, information on these subprime loans was publicly available as several popular blogs wrote about them. So was the market really efficient? If we’ve been witnessing a major change in market perception, what would happen when the market suddenly “discovers” the weakening economy?

My current game plan is to react to market trends while reducing risk exposure. The day before “grey Tuesday”, I wrote Caution is warranted based on the technical behavior of the broker/dealer index. At least in the next couple of weeks, I’ll weigh TA evidence more heavily than economic fundamental or market sentiment.

Best luck and be safe!