Time to Bet Against the Market

It was a beautiful summer weekend in Seattle, with record high temperatures and blue skies. When I looked out the window of my home office, I saw a sparkle of whitecaps on Lake Washington and heard the flapping of sails, the gunning of powerboats and the laughter of children.

Add to this idyllic scene the exciting sound of Olympics competition from television, and you’d be excused for thinking that all is exceedingly well in the world. There is a lot to be thankful for in August in the Northwest amid a respite from the clouds and rain.

The stock market has been trying to add to this sense of languid buoyancy, as equities have risen fitfully but smartly by 5.6% out of their mid-July low, and even the jumpiness of recent weeks has taken a break lately. (See also: "The Dollar Finally Makes a Move Higher.")

The CBOE Volatility Index ($VIX) fell beneath 20 on Friday, and no major businesses have declared bankruptcy for, gosh, a couple of weeks now.

So all is well, right?

Well, not so fast. The summer can often be a very deceiving time in the stock market, as investors distracted by good weather and vacations are lulled into a sense of complacency that often ends abruptly in September with a swift crack on the head.

The classic example in recent years came in 2000. The Nasdaq had fallen from its 5,000 peak to 3,000 from March to June, then zoomed back to 4,300 in mid-July before crashing by 17% to 3,520 by the end of that month. Tech stocks then turned about and soared a stunning 20% in August and everyone thought the evil genie was back in the bottle.

Except at the beginning of September, Intel (INTC) announced that its European sales were weakening, and the Nasdaq plunged 28% from then to mid-October en route to a drubbing that went on to last another two years.

It’s a little-remembered fact that Intel and many other chip makers did not peak in March 2000 with the rest of the Nasdaq. The semiconductor titan actually peaked on August 31 at $70 that year amid optimism that the blue chip would skirt the sales woes of a nascent recession starting to afflict smaller companies in Internet services and software.

Yet chip makers turned out to be only the last holdouts, as Intel ultimately fell as low as $12 over the next two years, and peers like Broadcom eventually sank to $6 from $180 while PMC Sierra (PMCS) plunged to $2.70 from $250.

I sure hope that little crease of history does not repeat, but I cannot lie I do get the sense that bulls are whistling past the graveyard in a similar fashion now, and that they’ll regret it before too long.

Although many financial institutions with clear exposure to subprime mortgage losses have been hammered already this year, supposed leaders like JP Morgan (JPM) and Wells Fargo (WFC) are still in relatively decent shape, down less than 25% from their all-time highs at a time when many big-cap banking peers are down 75% or more.

The reason I don’t think the WFCs and JPMs of the world can escape a drubbing is pretty simple. The only two companies with a now-explicit federal guarantee—government-sponsored mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE)—are seeing their bonds trade these days as if they were junk, or worse. And that is significant because the health of Fannie and Freddie debt tends to create a ceiling on how strongly the rest of financials and the corporate bond market can get.

It’s not a measure that’s visible to equity investors, but you need to know that a credit derivative index tracking the value of the subordinated debt of Fannie and Freddie this week blew out to levels similar to the ones that preceded the worst of the financial turmoil of last winter and early spring.

The relationship is pretty clear if you think about it: If the bonds of companies with a government guarantee are treated like trash, what hope is there for bonds of merely mortal firms?

Brian Reynolds, the independent credit analyst who’s my favorite maven on this subject, believes the perilous condition of the Fannie and Freddie credit default swaps suggests that losses at the big banks are not only going to continue, but actually accelerate lower.

Keep in mind that banks close their books on the third quarter earlier than other companies—at the end of August, not the end of September. So unless home prices and the loan business dramatically improve in the next two weeks, it’s entirely possible that the next loud sound you hear is disappointed investors blowing a gigantic hole in the side of one of the big banks that doubled off their July lows, such as Bank of America (BAC) or Wachovia (WB), if not actually WFC or JPM.

If that occurs, it won’t be pretty for any other section of the market as wel as retailers, techs and industrials are judged guilty by association. (See also: "August Could Be The Tipping Point.")

This is why I’m sticking to my forecast that while stocks have an opportunity now to trade higher by another 3.5% to the 1,335 area of the S&P 500 Index ($SPX), maybe even 1,370, they are then in danger of being belted and pushed back to the July lows and beyond. To prove I’m wrong, stocks have to trade above 1,370 for a week.

This is a pretty slim window, both in time and points, so it behooves us to continue to exercise caution.

If I’m right, I’m telling my subscribers in Trader’s Advantage the next big money-making opportunity for those of us with a  long-term approach will be a bet against the market in general, as well as against financials and basic materials makers. For details on a risk-free trial, click here.

Later in the week, I’ll give you more reasons that help me reach this point of view.  

Jon Markman is editor of Trader’s Advantage and a regular contributor to InvestorPlace.com. To get this type of actionable insight from Jon and other InvestorPlace Media experts visit www.InvestorPlace.com today!

Article printed from InvestorPlace Media, https://investorplace.com/2008/08/time-to-bet-against-the-market/.

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