In my last column “Expect a Bounce” I suggested that the markets were deeply oversold and a tradable bounce was in the offing. Thanks to several initiatives by the government last week, we indeed moved up over six percent from the lows. But don’t be fooled, a bounce is just that. We are definitely not out of the briar patch quite yet.
The trigger for this rally was three fold: a sudden (but expected) decline in energy prices, the introduction of temporary new short-selling rules for 19 commercial and investment bank stocks by the Security and Exchange Commission (SEC) and the proposed bail-out of Fannie Mae and Freddie Mac, the government -sponsored mortgage companies. I maintain that the decline in energy prices is at best temporary while the government intervention, no matter how well-intentioned, has only set the markets up for a further fall.
The bail out of Fannie and Freddie (see this week’s column “Why Fannie and Freddie had to be saved”) sent both stocks up over 100% in less than a week. At the same time, the SEC decreed that selling short “naked” shares of the top 19 brokers and bank stocks for the next 30 days is verboten. Selling stocks of companies you don’t own and borrowing the money on margin to accomplish this is called a “naked short”. On that day there just happened to be a record short position in those financial securities. The sudden announcement precipitated a classic short squeeze.
A buying panic erupted as huge hedge funds all tried to cover their shorts at the same time by buying the shares they sold. Other institutions also jumped in buying the beaten-down, over -sold financial sector stocks. That simply added to the squeeze. By the end of last week when the smoke cleared some big name financial stocks were up 25-45%. The ferocity of the upswing in financials simply dragged the rest of the market with it. This movement was also fueled by falling oil prices. That decline was greeted with relief by most investors who had become increasingly concerned that high energy prices would sink the economy and the consumer. So now we sit up here at the 1250 level on the S&P 500. We are in no-man’s land, betwixt and between support at 1180-1200 and resistance at 1300.
The question I have to ask is what happens next? Take the congressional passage of the Fannie/Freddie bail-out. Both stocks have declined over 20% since the announcement and closed even lower today. Investors, after a week of relief that the companies would not go belly up, are realizing that the mortgage companies still face huge challenges ahead.
And has anything truly changed in the fundamental outlook for the 19 banks and brokers thanks to the short-selling intervention? The problems they face will still be around once the temporary rule expires in another 20 days or so.
The answer, dear reader, is that this market is living on borrowed time. Could it move higher as some analysts are predicating? Sure for a couple more points. The S& P 500 could continue to struggle higher if oil prices continue to move lower. It will do so without me.
The potential for additional bad news to surface anywhere in the world is a high probability. Take the Russian stock market for example; it plunged today by 5.5%. Investors sold stocks when the head of British Petroleum’s joint venture with the country was refused a visa to return to his office in Moscow. It is an indication of how jittery investors truly are. I reiterate that this move up is purely a bounce in a market that must still re-test the lows.
But on the bright side, I do believe that we are approaching that bottom. I have often said that investors sell their most profitable holdings as we approach a bottom and in the last few days commodity stocks have taken an awful beating. That is a good sign. Patience in markets like this seldom disappoints.