Stocks May Be Oversold, But Be Ready For More

Looking at index charts, I am not sure whether the term “oversold” has much meaning in relation to our current market. Sure, we may get an oversold bounce, perhaps if we get an emergency rate cut. But lower interest rates will do nothing to solve the underlying problem. Moreover, the market may have already priced in the bailout. We are in a steep decline, and panic has yet to truly manifest itself.

Considering the underlying fundamentals, the market is almost certainly overvalued here. We are losing large corporations and wealth at a rapid rate, unemployment is increasing, tent cities are springing up around the country, the taxpayer is under an enormous burden of government debt, and earnings season is on the way. Yet, many homebuilder, airline, and consumer sector stocks are well off of their yearly lows, presumably because lower oil prices somehow changes the fundamental outlook for these companies. I’ve got news: the consumer isn’t going to save us here.

Richard Bernstein, Chief Investment Strategist at Merrill Lynch (MER), discussed the value of stocks in a recent interview. I do not know how long Mr. Bernstein has been at his position, considering Merrill’s investments have not panned out so well. In any case, his words are worth reading:

Could you talk a little more about stock valuations and your concerns there.

We have never had the combination of 5.5% inflation and about a 25 multiple on the S&P’s trailing earnings. When we talk about a 25 multiple on the S&P, nobody can believe that it’s actually the trailing earnings. And then people say, “Well, if that’s true, it’s only the financial stocks.” Well, it’s not. It’s much more broad-based.

The market is just legitimately expensive, and we are so hesitant to use forward earnings, because analysts haven’t revised their estimates downward. So to say the market is selling at 13, 14, 15 times forward earnings is a meaningless statement.

What’s ahead for the economy, and how much more pain will there be?

That’s a hard question to answer, but investors who are looking for a sharp V-shaped recovery are going to be quite disappointed. I don’t see that happening. That’s because we are going through Phase I of this process, which is the deflation of the credit bubble. Phase II is the knock-on effects on the real economy, and we’re just beginning to see that.

Looking at my sector scan, short term direction is quite difficult to discern. To me, the most interesting index ETF chart is the Russell 2000 Index ETF IWM (IWM). Today the price broke through the double bottom from January and March. Volume was not particularly high, but this price level is quite significant. A break below today’s low would provide a good short entry, with a stop over today’s closing price.

- FTSE/Xinhua China 25 Index (FXI): We have room for a bounce here, but if the price breaks 30.00, look out below.

- Financial Select Sector (XLF): I have generally steered clear of the financials during the past few weeks. Today I started to add some short exposure via puts. I would exit on a high volume break above the trendline.

- Regional Bank ETF (RKH): Regional banks have held up through the carnage. RKH is around 65% above its July low. Seems optimistic to me.

- Dow Jones Transportation Average ETF (IYT): The transports took a big digger today. I am considering buying puts tomorrow. This is the five year chart.

- Gold Shares ETF (GLD): I am long-term bullish on gold, but have lightened up considerably on today’s break below support. I am going to wait for signs of a bottom before re-entering a long position.

Airline stocks have started to break down, but have been whippy and remarkably resilient.

- UAL Corporation (UAUA): As I have mentioned before, United Airlines stock hit a low of 2.80 in July. I am looking to re-enter a short position below today’s low.

- TAM S.A. (TAM) looks like a good short on a bounce to the 20.00 area, or below 18.85 with volume.

- First Niagara Financial Group (FNFG) looks like it wants to go higher.

- Raymond James Financial (RJF): I would also consider a long position here if I see the volume coming in.

I am not seeing too many good entries on either the long or short side. At the same time, I think a large breakdown is far more likely here than a sustained rally. The best thing the bulls have going for them is a highly bearish investment community. Short positions and puts entered now may require patience, but will probably yield considerable profits in the not-too-distant future.

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