Waiting For The Counter-Trend Stock Rally

The nature of Friday’s sell-off, coming as it did after a morning rally and House passage of the bailout bill, indicates we have more downside before we hit bottom. At the same time, oversold conditions make it difficult to find good short entries. To review a few charts:

- Russell2000 index ETF IWM (IWM) broke decisively below the January and March lows, although with slightly below average volume.

- QQQQ (QQQQ) has seen a steep drop and is now very oversold.

All of the index charts tell a similar story. Given the market conditions, and lack of panic so far, we could simply continue downward until we see capitulation. However, I am expecting a rally sometime soon, perhaps driven by some Fed action on interest rates, or even a coordinated action between central banks. My strategy here is to remain heavy in cash and to knock out some day trades until the market provides advantageous setups either long or short. I am currently holding smaller short positions in ENER, IIVI, ILMN, PTNR, and SMTS. I also see good long term shorting opportunities in airlines, homebuilders, financials, and a number of consumer sector stocks. Within these sectors, I have been gradually accumulating puts, which I intend to hold for 1-3 months, or until I see the technical signs of a bottom.

My long term thesis is that credit issues will continue, and the crisis will start to manifest itself more clearly in the broader economy. If we get a good-sized bounce prior to the bulk of quarterly earnings reports, many charts will be setup for advantageous short sales.

Should we continue lower in the near term, here are a couple of charts that still look decent on the short side:

- Energy Conversion Devices (ENER): This one made my day on Friday, as I was adding short during the morning rally. Price rose to just under the 50 day moving average, then fell to close red on increasing volume. Looking at the chart, the most recent earnings report was in late August, which marked a double top, and subsequent fall.

- Lennar (LEN): Homebuilders were weak on Friday, with some volume to the selling.

Otherwise, it looks like the beginning of the week will provide some beach time. In the meantime, I am finding a lot of interesting analysis this weekend:

- Jeff Cooper provides some comparison of the current situation to the crashes of 1929 and 1987.

I think it is wise to respect the message of history and the notion that panics tend to play out over a certain periodicity of 49 to 55 days before being tempted to jump in because stocks look like they are down too far, because stocks look cheap. There is no such thing as fair value when someone big is trapped and forced to sell and they cannot wait. There is no such thing as fair value when hysteria is running rampant.

- Barry Ritholtz has some excellent articles on the conservative meme that that our problems are all due to the Community Reinvestment Act and Democrat pressure on financial institutions to provide loans to minorities and those with low incomes. The Republicans want to make this about race and class. I suppose this is partially to avoid blame, but it also plays as a typical political wedge issue. Go here and here.

- Also consider this very informative Hank Greenberg article from last December, where he quotes Mr. Mortgage, Mark Henson:

But sub-prime is what is being focused upon to draw attention away from the fact the lenders and Wall Street banks made all loans too easy to attain for everyone. They can explain away the reason sub-prime loans are imploding due to the weakness of the borrower.

How will they explain foreclosures in wealthy cities across the nation involving borrowers with 750 scores when their loan adjusts higher or terms change overnight because they reached their maximum negative potential on a neg-am Pay Option ARM for instance?

Sub-prime aren’t the only kind of loans imploding. Second mortgages, hybrid intermediate-term ARMS, and the soon-to-be infamous Pay Option ARM are also feeling substantial pressure.

…Second mortgages to 100% of the homes value with no income or asset documentation were among the best sellers at CITI, Wells, WAMU, Chase, National City and Countrywide. We now know these are worthless especially since values have indeed dropped and those who maxed out their liens with a 100% purchase or refi of a second now owe much more than their property is worth.

…In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise or home prices have to fall 50%. None, except the last sound remotely possible.

- This August 30 article reports, “Home sales increased 43.4 percent in July in California compared with the same period a year ago, while the median price of an existing home fell 40.3 percent, according to the California Association of Realtors.” The article includes a regional breakdown.

- Amy Houk has an article on the recent Mortgage Bankers Association study on foreclosures, including the following:

- “Altogether, more than 9% of mortgage loans are either delinquent or somewhere in the foreclosure process.”
- “California and Florida alone accounted for 39% of all of the foreclosures started nationally during the second quarter.”
- “The delinquency breakdown supports the argument that the foreclosures are being driven by housing fundamentals as opposed to economic issues such as job losses.”

This last point feeds back into my earlier comments about the credit crisis spreading into a broader domestic and global crisis. The first stage of the problem was due to an asset bubble and over-leveraged financial institutions. The downward spiral in housing is likely to continue as the consumer and general economy start to experience the consequences in a more tangible fashion.

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