Stocks over the past week have run up on excitement over the government’s attempt to rescue U.S. mortgage finance titans Fannie Mae (FNM) and Freddie Mac (FRE), but now a sense of reality is settling in.
On Thursday, you could almost audibly hear investors asking themselves whether the current administration, which has proven largely inept in financial matters, could really pull off the coup of a generation by killing off short-sellers and oil speculators while at the same time quelling inflation and turning banks’ losses into profits.
In times like this, I think it’s useful to create a set of scenarios that help guide your investing so you don’t get overwhelmed by volatility of the moment.
Looking out over the horizon of the next six months, I have already told you that the market has a shot at getting to the 1,325 to 1,335 area of the S&P 500 index before bears get out the heavy artillery and shell the advance. (See also: "Sellers Aren’t Done Yet.")
But setting a line in the sand is only half the battle. Another key question is how we get to that level.
I have three scenarios in mind now. Here they are.
Scenario 1: The market trades straight up to the 1,330 of the S&P 500 Index from here, then hits the wall and is repelled back down to the July low of 1,200. A trading range is then set and the market trades up and down within the 1,200 to 1,330 range over the next three months before sinking below 1,200 in October and heading toward my ultimate target, which is 960 next year.
Scenario 2: The market trades down for a retest at 1,200 fairly soon as a technical retest of the lows following a sharp rebound in energy prices then trades up to 1,330 by mid-August—and then crashes back below the 1,200 level in September and October.
Scenario 3: The market doesn’t quite get to 1,330 over the next few months, but doesn’t decline much either. We enter a frustrating sideways trading range within 50 points of the current level before finally falling to retest 1,200 in the autumn. That test holds and then we’re off the races for a typical fourth-quarter sprint higher.
Why would the market trade up at all, given the difficulties at banks and brokerages?
It’s simply the fact that the government so far has leveraged the trading savvy brought to the Treasury Department by Secretary Henry Paulson, a former Goldman Sachs executive, to join hands with the Federal Reserve and the Securities & Exchange Commission for a raid on short-sellers. (To learn more, read: "New Government Role Jeopardizes Bank Stocks.")
Sorry to sound cynical, but I think it’ easier for the T-men to put legitimate speculators out of business, and place bandages on the financial systems’ broken limbs, than to create real solutions.
This artificial pumping-up of banks/brokerages’ shares allowed them to trough last week at cheap but not super-cheap levels, and at some point gravity will take over and they will have to get as inexpensive as they were in 1990 in order for a final low to be set.
As one of my research partners in the hedge fund business told me this week, one way to think about the Fed and Treasury action is that the government has smoothed out the usual bankruptcy cycle to control systemic risk. But after a round of short-covering ends, the financial stocks are likely to start responding more to fundamentals.
In this event, my colleague suggests, bad companies will go down, good companies will buy assets cheaply and trophy companies (like UBS and Citigroup) will get large investors even if they don’t deserve it. So all in all, the trading range part of my scenarios is just a suggestion that we’ll see something similar to what happened to technology following 2002.
The better companies like Oracle (ORCL), Cisco Systems (CSCO) and Intel (INTC) did advance for a couple of years but never came anywhere close to their former glory, while more modestly endowed cousins like Tellabs (TLAB) and JDS Uniphase (JDSU) just limped along at much lower levels and lousy companies like Exodus Communications, Lycos and Excite disappeared.
Next week, I’ll explain how the commodity stocks fit into these scenarios, so be sure to tune in.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.
