US Stock Market: A Dead Cat Bounce In An Overall Ill Market?

On Friday, the bulls were able to register a win, with major indexes breaking slightly out of declining channels. Looking at Thursday and Friday together, traders demonstrated indecision more than anything else, sending averages up in down in a narrowing range. It felt as though short covering was driving much of the action, with a lack of follow through on Friday’s gap up, and frenzied rallies off of the lows when selling had dried up.

Price is still below the 10 and 50 day moving averages.

Although we closed higher on Friday, an options expiration day before a three day weekend before an inauguration, there is good reason to be skeptical. Reason number one is the action in financials. XLF (XLF) is looking oversold, but so far it is still falling.

During the past week, Bank of America’s (BAC) stock sank from 12.86 to 7.18, a loss of approximately 45% of it value, or roughly $28 billion in market cap.

There was carnage throughout the financial sector, as Citigroup (C) also declined from 6.54 to 3.50, another enormous loss of shareholder equity. Douglas A. McIntyre updates us on the government’s reaction:

The Fed has passed tens of billions of dollars of loans to banks and brokerages through its emergency lending window. It has lowered interest rates to zero. Treasury has put $25 billion into each of the money center banks. It is now backing over $300 billion in bad assets held by CItigroup (C) through a loss-sharing agreement. Bank of America (BAC) is getting a similar deal. The programs to back bad assets is almost certainly going to spread.

Over the last several days, the incoming administration has moved toward the idea of creating one federal agency which would have the purpose of taking most of the toxic assets off bank balance sheets. Since the figure at Citi is probably at least as large as the $300 billion pool that the government is guaranteeing, the combination of bad paper from Bank of America, Wells Fargo (WFC), JPMorgan (JPM), and the next tier of large US banks is almost certainly close to $1 trillion.

As evidence mounts that each of our major financial institutions is insolvent, the consequences cannot be positive for the market or broader economy. The only caveat is that perhaps there is excess liquidity, created mainly by the government’s actions, which could conceivably flow into equities.

For instance, commodity and energy stocks still appear technically as though they have room to rally, and many could legitimately be considered value plays at current levels. The Jeffries Commodity Index shows higher highs and lows. With the declining 50 day moving average just above, this is not an entirely bullish chart, but there is reason to think it may go higher from here. If money starts flowing into commodity stocks and we get a good oversold bounce in financials, the market could be off to the races in the short term.

On the other hand, the weight of economic evidence is more likely to break the market sooner rather than later. As Mr. Mortgage reports, December California mortgage defaults were up 100% month-over-month.

With the economy bleeding jobs, our financial institutions failing, and the the government piling on trillions of additional taxpayer debt, how much longer can homebuilder, real estate, and retail stocks remain 50, 70, or even more than 100 percent above their November lows?

The answer, considering last week’s action in bank stocks, is probably not long. So far many investor have been working with the notion that the bottom is in. Trailing earnings and yields make stocks look cheap, especially if one fails to adequately consider future earnings and the probability of dividend cuts (particularly when it comes to REITs). The analyst community has been overly optimistic throughout this crisis. As we get into earnings season, the greater likelihood is that companies will miss on earnings and guide down. The load on the camel’s back is getting heavier and heavier.

If we look at the chart for IYR (IYR), we can see price moved higher to end the week, with increased volume. However, we are still trending lower, with a declining 50 day moving average immediately above current price. Bank troubles indicate broader credit issues are likely expanding. We could squeeze higher from this level, but this ETF looks as though it will trade significantly lower in the near term.

- RTH (RTH) rose back above resistance on increasing volume on Friday. Wherever this mini-rally ends, it seem likely the following move will large and down.

- Centex (CTX): Most homebuilder stock are trading around a line of support. CTX has held support around 9.60. A break below this level would provide a good short entry.

- Meritage Homes (MTH) has failed to get through 15.30 on three occasions, and sits at its rising trendline, and under a declining 50 day moving average. The homebuilder stocks can have huge short-covering rallies, so it pays to be careful when shorting. Always use a stop. If the market shows signs of distribution, I will be looking to short homebuilders and ride them a good distance down.

- Mastercard (MA) is another stock that gives us a gauge of the broader economy. Price broke down last week on heavy volume. I will be shorting if I see a low volume bounce into resistance.

So in a nutshell, the bulls may drive us a bit higher in the short term, but the overall market is looking ill, and buyers tentative. Scaling into retail, homebuilder, and real estate shorts, and shorting strength, would seem to be the highest probability plays here.

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