Look out below! Market setting up to fall.

With the last legs of this rally really more of a sideways trade on very light volume, we’re starting to see some signs that a rolling over process has begun.  While there is plenty of reasons to be a bear, the most compelling reason to be a bull was the notion that things were getting worse at a slower pace.  The idea was that we overcorrected to the downside in March, facing what appeared to be a depression, and having (at least temporarily) taken that off the table, we see very attractive valuations.

We’ve had a nice run already

After about 40% off the bottom, I think we can say the valuations have gotten ahead of themselves.  In addition, there are no signs of an earnings-led recovery or any real green shoots that indicate we’ll be seeing a pronounced rebound in the economy.  Most of the optimism is coming from China, which seems to be hoarding commodities for its own hedging game against the falling US dollar.  While hunger for raw materials is good for the markets, if it is not a genuine appetite that stems from growth, but rather a desire to build a materials portfolio for the Chinese government, then much of the optimism in energy, materials and other related sectors is overdone.

The biggest driver is not behind the wheel

The consumer is facing more foreclosures, credit card defaults and an increasingly tight employment picture.  This is not the atmosphere that is condusive towards a consumer-led recovery.  Consumers probably have 5-10 years before they can start to lever up again on their credit.  Other emerging markets are attempting to build consumer economies, and facing tremendous headwinds from populations who treasure thrift rather than spending.  The appetite for material possessions is not nearly as strong nor are earnings per capita elsewhere enough to sustain the vacuum left behind by the American and European economic implosion.

Greenflation not back, yet

Green energy is a promising sector when crude oil is above $100.  Right now the motivation is just not as strong with consumers or companies to make big moves in to more environmentally sustainable energy.  I believe that once inflation makes energy less affordable the appetite for green energy will increase.  This may be a while off depending on how fast the global economy can pick up the slack left behind from the last bubble.

Climb a plateau once its peaked…

So where is the catalyst for the next rally?  What could drive equities higher?  The only way we’re going to see a tremendous rally from here is if we see much more currency debasement and intentional inflation.  That kind of manipulation could continue to lead markets higher, but at the cost of the currency that equities are priced in therefore nullifying much of the gains.

Or fall right off?

I think the market is setting up to fall.  I’m not so sure we’ll retest the lows or not, but I do think we’ll see some more selling as fundamentals begin to play a center role in the stock market again.  On a technical note, we may be building a pretty significant head and shoulders pattern on the S&P 500.  Today’s action seems to confirm the right shoulder.  We could see a retest of 875 or lower if it continues to play out.

Feeling frothy?

As the rally appears to be running on fumes at this point, I’d like to say that I was a little early saying to sell it before, but one never can trust a bear market rally.  That’s what it still seems like we’re dealing with, too.  The technicals were powerful during the 8 week surge, but we do not yet have a Dow theory buy signal (need a close above 9125) or a break above the 200 day moving average on the S&P 500.  Now the charts are beginning to look more exhausted as the overbought conditions are worked out.  Longer term the trend remains down as we seem to continue with the 10+ year double top formation playing out on the S&P 500.

Banks led the rally up and now they are beginning to give way as fundamentals point to a more pessimistic picture than the prior trading action of their equities might suggest.  While I do feel that the substantive cash injections, ZIRP cheap liquidity and stimulus have filled part of the vacuum left by the implosion of Lehman and the deleveraging process, there is simply too much enthusiasm around when this alleged recovery is due to transpire.

We are quite literally in the midst of a complete reinvention of how the world does business and in that process there likely will be further dislocations and market abberations before settling in to a U or L-shaped recovery — either economic destiny will be determined by the shape of fiscal policy and whether insolvent institutions are infact allowed to fail or continue indefinitely as “zombies”.  Unregulated derivatives markets must be brought in to the light and fully regulated in order to prevent credit default swaps and other leveraged contracts from contributing to widespread system disruptions.

This turning point has been marked by the downfall of the US as the financial capital of the world.  A slow unwinding process that in the decades to come will be much more apparent than it is now.  This is the unfortunate consequence of being the largest debt bearing nation in the world whose currency is quickly losing popularity as reserves for central bankers around the world.  The unraveling is going to degrade the quality of life for Americans and boost domestic inflation considerably.

If nothing can be done to restore confidence by regulating the shadow markets and unraveling the insolvent institutions, then this trying period shall last quite a while.  At this point I don’t feel the actions of the US government or the Federal Reserve have been constructive to that end.  That is why I feel the rally is largely unsustainable and right now we are in a frothy period where short positions in equities and long positions in foreign currencies may be appropriate to consider putting back on the table.

Disclosure: Short US equities, long foreign currencies

Anatomy of a bear market rally

Why have we witnessed four up days of trading that rocketed from the lows of 741 to nearly 890 on the S&P 500? Is it the start of a new bull market? This would be a very pleasant scenario, but bear market rallies can last days or sometimes even weeks and months. The most violent rallies, like those as of late, are generally short lived. The last time the market was up four days in a row was April, 2008.

How are bear market rallies possible?

Lately we’ve seen anything from government appointments to bail outs of multinational banks significantly lend to positive momentum. This is quite a contrast from the traditional inspiration of good earnings or economic data.

Bear market rallies are not created by investors buying to commit capital in to a stock for the long term, but instead by short covering and trading. The short term horizon of the participants and the lack of fundamental positive catalysts usually lends to these rallies collapsing to worse levels than they had climbed from, rather than a constructive bottom forming process.

When will we see the bottom?

A) The worst must be over: House prices are still dropping, unemployment is rising, consumer sentiment pushing all time lows and credit availability is tight. There is likely another leg down coming in both commercial mortgage backed securities and consumer credit card defaults.

B) There must be a positive catalyst within sight: Green energy has been promised to be the next bull market. Is there demand for these measures when oil is at $50 a barrel? The other question is, after committing half of last year’s GDP to financial bail out programs, how will the Federal Reserve and US Government continue to finance their spending? More importantly, will foreigners continue to lend to a less credit worthy nation?

C) The Federal Reserve must complete lowering rates and change to a neutral or tightening bias: The next Fed move will likely be another rate cut. To Bernanke’s Fed, deflation is still a bigger threat and he has the helo running full time dropping cash. Until this reactionary behavior is over, there is no sign that we are out of the woods.

D) Businesses must begin buying back shares: Many buyback programs have been halted, not accelerated. We have not seen corporations step back in and buy back their own shares. We also haven’t seen many insiders provide substantial equity commitments in their companies as of late. This is an important component of building a sustainable bottom.

E) Risk indicators must begin to show signs of significantly decreased aversion: The Japanese Yen, crude oil, one and three month T-bills (and lately even the long bonds) have all shown us that the flight to quality and away from risk (or growth) remains. The VIX is still above 50 and has major support at 45. Even gold prices are back above $800. Fear still seems to be a greater motivation than greed.

What are the charts saying?

Structural bear market in S&P 500

The above S&P 500 chart is not confidence inspiring. The trend lines illustrate the wedge patterns and the horizontal lines show major resistance areas.  Currently the stock market is bumping in to major resistance. My indicators confirm this rally is overbought and due for a correction soon. 

Where are we heading next?

Based off the above analysis, I don’t feel this rally will get much above 900. Instead, we need to retest the intraday low of 741 on the S&P in the next few weeks.  There will probably be support areas on the way down at 875, 850, 830, 800 and 776. If the 741 low doesn’t hold, 600 is the next level of major chart support.

If you’ve made some money on the rally, don’t fall in love with the upside.  Remember that we still have a lot of problems to work through.  Folks with investments should use this as an opportunity to raise cash. If you’re looking to trade this rally, you may want to begin adding to short positions.  FinViz.com has some great tools for screening stocks if you use technical analysis to find your trades.  Good luck and stay safe!