MolloMarketReport

Are Happy Days Here Again?

            The last two days have seen a monster rally in the markets.  The Dow Jones Industrial Average has spiked 4.42% in the last two days, the Nasdaq is up 4.32% and the Standard and Poor’s has rallied 3.74%.  Oil on the other hand has plummeted over 10% and has broken through the $130 level; a level I was saying we needed to cross to leave the extreme uptrend.  So what is going on?  Have we turned the corner and seen the bottom, or is this just another Bear market rally.  I’d like to look at some of the recent events that I believe have led to the market rally as well as some of the aspects of that rally and see if this rally is the real deal.

Oil

            A big part of the boost in the market is some long overdue relief in the price of oil.  A number of news outlets have pointed out a government report that came out showing a still growing inventory of oil and gasolines as Americans (and others) have cut back on energy use.  But I think this reason is given too much weight.  There have been a number of supply reports out since the 4^th of July about demand being cut back.  It could be that this last report was the straw that broke the camels back, but I think where the camels live is what has really been driving this drop– the Middle East.  Throughout last week Israel and Iran were furiously rattling sabers, and even as late as Monday the Iranians were threatening to cut off our hands if US soldiers set foot in their country.  But on Tuesday evening there was a news report that the Bush administration was sending a senior envoy to meet with Iran’s chief nuclear negotiator.  Now the administration was quick to point out that the envoy was only going to tell Iran that we won’t talk to them unless they give up nukes, but it was a big shift in policy.  Rather then further escalation of rhetoric, we are seeing de-escalation.  On Wednesday the price of oil continued its decline.  Since then there has been news of a big prisoner exchange (and return of remains) between Israel and Hezbollah, and that the United States is considering opening an embassy in Tehran for the first time since the 1979.  The headlines were harping on Middle East tensions for oils rise last week, why are we not hearing about this news in the context of the falling price of oil?  Keep in mind just because this uptrend is broken does not necessarily mean we will see a drop.  We could see a consolidation of prices before heading higher, or just a sideways market.  The price of gasoline will lag the price of oil, especially on the downside so although a break of the uptrend is positive, don’t put on your party hat yet!

Short Squeeze

            On Tuesday, the SEC created emergency rules that disallowed “naked” shorting of Fannie, Freddie and other financial firms.  I’m guessing that this quick fix for the market yanked a lot of sell side pressure off of these firms.  Those who wanted to naked short could no longer do so.  Those who already were naked short had to close their positions.  I’m not sure if that was part of the mandate of the emergency rule, but if I had a naked short position, I have to assume that I could be required to do so at some point soon.  Others who are short could also be uneasy about holding their positions as they consider if their positions will be outlawed next.  As the initial shorts cover, it pushes the market up forcing more short to cover spiraling into an upside crash.  The problem is that this fuel to the rally will not last.  It doesn’t do anything to improve the profitability of financial firms or the markets perception of them.  Ultimately that is what the price of securities are based on.  If the price of those securities is going to go down, they will go down even without short sellers; they will only do so in a less efficient manner.  We seem to be in a dangerous place for the market as a mechanism with first this rule by fiat of the executive branch, and the constant murmurs in Congress about preventing “speculators” in the oil market to keep the price down.  Where does this end?  Will the Federal government micromanage all the prices we don’t like?  The fact that this rally has been led by the financials makes me worry that this short squeeze element is a big piece of the rally and hence a big piece of this rally is fake.

Earnings

            A large number of companies are or have reported earnings this week.  This constant barrage of news can often rock the financial markets.  If there is a good deal of fear markets might sell of prior to earnings because of that fear.  Then as news comes out, that fear dissipates and investors feel confident to buy again.  It looks like there is a lot of that going around.  Over the weekend we saw people standing in line at Indymac, and rumors of Freddie and Fannie going under.  This significantly lowered expectations, and if earnings are less bad then expected there is a lot of relief in the market.  Wells Fargo took it one step further and not only released better than expected earnings, they also raised there dividend.  This is a strong signal to Wall Street of confidence in future earnings.

Vix

            On Wednesday the CBOE Volatility Index spiked over 38.  The August of 2007, and January and March lows of this year saws spikes of the Vix over 35.  Unfortunately all of those lows were only temporary.  From a technical perspective this is a very strong signal.  Wednesday’s Vix action makes me think that we likely have a short to medium term bottom in place.  There would need to be some tests of that bottom before I would become more confident.

Inflation

            Yesterday we had a report that prices had the fastest rise in 26 years with prices up 1.1% month over month and up more than 5% year over year.  The market rallied despite this fact.  If the oil element slows or even reverses this number could be as bad as it is going to get, which would be a signal of a bottom.  But, if it is something that will continue, inflation will drag upon the economy.  And as I have said it is something that needs to be taken care of before the economy can improve.

Summation

            A rally like this certainly feels good.  My feeling on whether it is real or not is mixed.  The oil news is good, but energy prices have to come down much more to stop being a drag on the economy.  The short rule boost worries me a lot especially as the financials have led the rally and produced their best day on Wednesday in history.  The Vix seems to imply that we have put in a short term bottom, but it doesn’t say much beyond a few months.  I think we will see another test of this bottom and if the bottom holds I would be cautiously bullish near term (2-3 months), but cautiously bearish for any time period after that.

David Mollo

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