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Thursday, 30 July 2009

Have We Reached a Top?

By James Kostohryz

It's never been my position that the flow of fundamental news would turn from positive to negative overnight and in a total fashion. The world simply doesn't work that way.

When I terminated my core long position a couple of weeks ago for reasons explained in�Ten Reasons the Countertrend Rally May Be Over,�I outlined a series of factors I believe may manifest in the later half of 2009 and the first half of 2010. Indeed, most of these factors will be more back-end loaded, as negative factors tend to build on one another and gain momentum in time through the medium of psychology and social mood.

It's my view that the flow of economically relevant events�-- and perceptions of these events --are in the early stages of a transition. In this case, a transition means the flow of relatively good news will tend to wane somewhat while there's an uptick in relatively bad news. This is what one would expect at a top.

However, it's to be expected that during the transition (or topping process), the distribution of news flow between good and bad will even out for a while.

Let's take recent data for an example. On May 14, I wrote an article positing the prospect for a short-term rebound in housing prices. At the time, I was roundly criticized for even suggesting the possibility. Well, since the article was written, we've witnessed 3 consecutive months of increases in home sales, and today we got the first month-over-month increase in home prices. This is very bullish.

Also bullish was the Richmond Fed number today as well as most of the recently released PMIs. Leading indicators have been telling us for over a month that a recovery of some sorts was right around the corner. And earnings have been beating the socks off consensus estimates.

Yet it's not all a bed of roses. The revenue numbers in the earnings reports have been underwhelming. Positive and negative surprises for revenue are running about even. However, there have been quite a few massive misses, which put a negative tinge on the revenue data overall. Some bearish analysts have started to spin this revenue data into a complaint about the bad "quality" of earnings.

Perhaps even more ominous for the future is the turn in consumer sentiment. Today's number registered 46.6 versus an expected 49 � a significant miss. This is the second straight month of declines after the index reached an intermediate term peak in May at 54.8. This is a very pronounced shift in reported sentiment in such a short time frame. Remember, psychology is the filter through which human beings see the world. This is critical at a time like this.

As I've mentioned before, it's my belief that the key metric to look at as a proxy for consumer and business confidence is President Obama's approval ratings. They've steadily declined despite a strongly rising stock market. This brings up a most worrisome query to keep in the back of our minds as we go forward: Where would�the ratings�be if the market�was declining? Where will they be if the market�begins to decline?

The most disturbing thing reflected in the polling is the sharp rise in the unfavorable ratings for the new president. According to pollster Scot Rasmussen, only 32% of Americans "strongly approve" of Obama's presidency where as 40% "strongly disapprove." The latter figure has increased by over 10 points in little over a month. It's the worst reading for a president so early in his first term. Perceptions of Obama as being an extreme liberal have also skyrocketed: 48% of Americans classify him as "Very Liberal" which is up 20 points since he was elected.

All of this signals future political polarization, gridlock, and a souring social mood. Most importantly, it's signaling an erosion of confidence in the government's ability to lead the nation out of its current economic crisis.

After earnings season is out of the way, the market will necessarily focus its attention on macro factors. I don't expect the data to give definitive answers in the debate between bulls and bears. To the contrary, we should expect confusing and contradictory signals.

This is to be expected when the market is undergoing the first stage of a transition --�from mostly positive news flow to equally positive and negative news flow and then to mostly negative news flow. And, remember: The news isn't just about the cold hard data. It's�also about the�way the data is interpreted. In this regard, keep an eye on Obama's poll numbers. They should serve as a good proxy for social mood; they'll give us clues as to whether economic data will tend to be perceived positively or negatively.

The trading stance? Some bearish positions include a put on Deutsche Bank (DB), a short on Banco Santeander (STD), long PowerShares DB Crude Oil Double Short ETN (DTO), a put on Market Vectors Russia ETF (RSX), short Freeport McMoRan (FCX), and short iShares MSCI Emerging Markets Index (EEM). Long positions include Apple (AAPL), Palm (PALM), Google (GOOG) and Bank of America (BAC). I am probing with a net short position gingerly, on a trading basis, with tight stops. I short SPDRs (SPY) and/or go long UltraShort S&P500 ProShares (SDS) to build net short exposure. I do not have a core net short position. I don't have a core short position; I have a trading net short position, and the distinction is important.

On an intraday basis, I'm even willing to go net long�-- particularly when support levels are tested. My hypothesis is that this is a top. As such, one must be cognizant that it can blow to the upside.

The time for more aggressive shorting may come in the latter part of the year as some of the factors I mentioned in�Ten Reasons the Countertrend Rally May�Be Over begin to manifest�-- particularly with regard to events in Europe. It's my view that the market is in a transition�-- there are currents flowing both ways -- and my trading stance reflects this.

Nothing contained in this article is intended as a solicitation for business of any kind or for investment in the firm.

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