Why The Correction Will Probably Resume! (TZA, DXD, FAZ, VXX, SDS, SSO, QID)

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July 4, 2011 8:45pm NYSE:DXD NYSE:FAZ

Sy Harding:  My weekend column ‘The Summer Rally Arrived On Schedule’ was a brief recounting of why the rally was predictable. Is what will follow also predictable?

Making the rally predictable was the market’s obvious short-term oversold condition after seven down weeks out of the previous eight, and the short-term seasonal pattern of the market almost always being positive in the days surrounding the end of the month (what I have always referred to as the ‘monthly strength period’).

The latter pattern was discovered in the 1970’s. Former newsletter editor Norman Fosback wrote of it in his 1976 book Market Logic, and developed a short-term trading strategy around it in his newsletter. The strategy called for entering the market on the next to last trading day each month and exiting on the 4th trading day of the following month. It was a top-performing strategy, its main problem being the cost of frequent transactions back in those days before discount brokerage firms arrived on the scene. Mark Hulbert continued to track the pattern on his own after Fosback retired, and has written that it is the best performing long-term timing strategy he has ever tracked.

The pattern is due to the large extra chunks of money that flow automatically into the market at the end of each month; from stock and bond dividends, most of which are paid at the end of each month and are marked for automatic re-investment, from investors following a strategy of dollar-cost-averaging into the market on a monthly basis, etc. JP Morgan notes that some $92 billion of payments on municipal bonds alone are paid on the first of the month, with most such bonds owned by insurance companies and trust departments that automatically reinvest those payments into the market.

In the years since its discovery the pattern has been enhanced by traders jumping into the market a day or two earlier in anticipation of the brief market bounce.

Then there is the influence of ‘window dressing’ at the end of each quarter, which is one of the reasons the days surrounding the July 4th holiday in particular tend to follow the end-of-month pattern.

Randall Forsyth covers it very well in an article on Barrons.com on Thursday, which he titled It’s That Time of Year: Calendar Trumps Fundamentals

Some quotes from it:

“Professional money managers call it “window dressing” when they adjust their portfolios to show winning stocks and cull out securities that would elicit reactions along the lines of “What were you thinking?” from their boss and clients.

Barry Ritholtz, author of the The Big Picture blog (www.ritholtz.com) in his spare waking moments when he’s not taking care of business as the chief executive and director of equity research of Fusion IQ, suggests that’s been at work in recent days as the second quarter draws to a close.

“With six of the past seven weeks in the red, the markets have managed to string together a series of winning days,” Ritholtz wrote Wednesday morning. “Daily gains both this week and last have ranged between 0.50% and 1.25%. Indeed, the Dow’s gains on Monday and Tuesday represent the first consecutive triple-digit gain for the Industrials since Dec. 1- 2. This was the fourth triple-digit rally since the April 29th highs.” Wednesday, the Dow managed to tack on only 72 points, but at 0.6%, the Industrials continued the streak of gains of 0.5%-1.25%.

But there seems less there than meets the eye. “I suspect it is simply a case of funds marking up stocks into the close of the second quarter,” he contends.

Okay, but why do I believe it is still just the brief short-term rally I’ve been predicting, and that the correction will resume?

After all, it was a much stronger than normal end-of-month rally, and that was different.

First, as mentioned in my weekend column, there is the appearance of the rally itself.

Technically, volume in the rally has been very light, less than 0.8 billion shares traded daily on the NYSE, compared to as many as 1.6 billion on the down-days during the correction. That indicates large institutional investors that were selling during the correction, are not believers in the sustainability of the rally and are not participating, but just waiting for the rally to end before getting back to selling down their portfolios further.

And as I noted in recent blog posts, investor sentiment, which is almost always at an extreme of bearishness at rally and correction lows, came off the typical high level of bullishness seen at the top, but fell only to  neutral levels in the correction, not to the extreme of bearishness usually seen at lows. 

Or as Barry Ritholtz also says in the Forsyth article, “What data supports this thesis? I would point to two things: psychology and trading volume. Most metrics are showing psychology is either neutral or optimistic. This tends to be supportive of a short-term trading bounce, and not a longer-lasting rally.

“Second, the volume has been anemic, even by the unusually low levels we have seen all year. The overall volume on Monday was well below the 30-day average on both NYSE and Nasdaq. Tuesday was even lower. Rallies on increasingly lighter volume are not signs of aggressive institutional buying. Rather, it supports the window-dressing thesis.”

Then we have the economy.

Wall Street will latch onto whatever it can find that is positive to explain why the market is acting as it is, even though its action was predictable based on the oversold condition, monthly seasonality, and end-of-quarter window-dressing weeks before the facts they latch onto were known.

So this week they credited the relief earlier in the week over the parliamentary vote in Greece, and the minor bounce in the ISM Mfg Index on Friday, while totally ignoring the months-long string of deteriorating reports, which continued to deteriorate further this week, including that construction spending fell again in May, that Consumer Confidence fell again in June (to a 7-month low), that weekly unemployment claims remained high at 428,000 last week.

It is almost a guarantee that the market would have been positive due to the extra chunks of money at month-ends and quarter-end window dressing even if the Greek vote and the ISM Index had gone the other way.

Let’s take a look at economic conditions and the outlook going forward.

And let’s look at the two positive reports of the week first.

The Greek vote means Greece will not immediately default on its debt, which would have probably resulted in a banking crisis in Europe that would spread globally.

But the vote merely left the status quo in place, of global economies slowing faster than previously realized as a result of, among other things, austerity measures being implemented to tackle government debt and budget deficits, or to slow economies in an effort to ward off inflation.      

The ISM Mfg Index did rise to 55.3 in June from 53.5 in May (which was the slowest growth in 20 months). But that was pretty much a stand alone report.

Another of the week’s reports was that Construction Spending declined in May, just barely above an 11-year low, the result of budget cuts at the state and local levels, more of which are on the way.

Here’s another problem. Consumer spending accounts for 75% to 80% of GDP in the U.S., and it was flat in June, at the weakest reading in 12 months.

Will it pick up? Probably not. Consumer confidence fell again in June. It’s also interesting that, exactly two years after the recession ended, at 58.5 consumer confidence is well below its average level of 87.0 two years after the last three recessions ended. Something is not working in this recovery.

And austerity measures are coming in the U.S., as Congress and the White House hammer out the details of where the spending cuts will come, and whether tax increases will be added.

And as is made clear by the riots, protests, and labor strikes not only in Greece and Portugal, but in the United Kingdom, Italy, Spain, etc., austerity measures do not improve consumer confidence about the future. 

Meanwhile, globally, China, the world’s 2nd largest economy, has been aggressively trying to slow its economy for more than a year, through interest rate hikes and monetary and fiscal tightening, raising concerns that it will inadvertently bring its economy in for a hard landing, in recession. And this week it was reported that slowing manufacturing activity in China unexpectedly fell to it slowest pace in 28 months, dragged down by rising interest rates and declining exports (as other global economies also slow and buy fewer Chinese products).

And while the ISM Mfg Index in the U.S. rose some in June, the PMI Mfg Index in the 17-nation eurozone declined from 54.6 in May to 52.0 in June, its slowest pace in 18 months. The combined economies of the European Union (eurozone) are actually the largest economy in the world, larger than that of the U.S.

And in the United Kingdom, which is not a member of the eurozone, and is the 5th largest economy in the world, its PMI Mfg Index fell from 52.0 in May to 51.3 in June, its slowest pace in 21 months.

So, put it all together, and there are reasons to expect U.S. and global economies to continue to deteriorate, and therefore to be suspicious of the low volume month-end stock market rally being anything more than the ‘monthly strength period’ and quarter-end window-dressing.

Meanwhile, our short-term technical indicators, which helped predict the rally, remain on the buy signal, indicating the rally may have further to go. But the market is already short-term overbought above its short-term 21-day m.a., and the market remains in its previous pattern of lower highs and lower lows that began with the April top.

So we shall see. 


Earnings Surprises Are On the Way – But Be Careful What you Believe!

Second quarter earnings reports will begin coming out soon, and as always Wall Street has been carefully guided by corporate managements.

So the Street knows just where to place their earnings estimates so that even if a company reports a big loss, it can be said that it “beat Wall Street’s estimates”.

Since it’s getting late, I’m going to take the easy way out this morning and just provide you with this link to a Wall Street Journal article titled  Earnings Surprises Don’t Add Up.

Related Tickers: Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA), ProShares UltraShort Dow30 (NYSE:DXD), Direxion Daily Financial Bear 3X Shares (NYSE:FAZ),  iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX), ProShares UltraShort S&P500 (NYSE:SDS), ProShares Ultra S&P500 ETF (NYSE:SSO), ProShares UltraShort QQQ ETF (NYSE:QID).

Written By Sy Harding From Street Smart Report

Sy Harding is editor of the Street Smart Report, and the free market blog, www.streetsmartpost.com.  The Street Smart Report Online includes research and analysis on the economy and markets, and provides charts and buy and sell signals on the major market indexes, sectors, bonds, gold, individual stocks and etf’s, including short-sales and ‘inverse’ etf’s.  It provides two model portfolios as guides. One is based on our Seasonal Timing Strategy, one on our Market-Timing Strategy.

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