A Commentary on Technical Developments and Rate Sensitive Financials

This week's trading action in most Financials, Retailers, Homebuilders and Industrials we follow has now traced out what appear to be bottoms that are typical of major lows. Whether these are major lows or not we won't know right away. Tough call as the critical element of time is an issue. Nevertheless, we've had heavy volume selloffs, followed by heavy volume upthrusts. The pullbacks have been minimal in magnitude and met with accumulation. Some will argue that since those are admittedly the industries with the most fundamental problems and have a relatively high sensitivity to macro developments which are not likely to be conclusively resolved, that selling pressure has simply been momentarily suspended. We respectfully disagree.

Of course its the case that some shorts cashed in profits and other late to the game shorts that dove in near lows cried uncle. But is it the case that one should conclude that the recent rally off lows is nothing more than a very oversold rally in a young bear market that should be shorted? We doubt it should be so easily dismissed because it appears to me that there has not only been a sharp retracement of the last move lower; but selling also seems to have dried up. Thats how stocks bottom - not because crazy numbers of buyers come out of the woodwork; rather its because sellers have sold all they wanted to sell and the weakest longs throw in the towel. The price-volume correlation also shifts noticeably.

Today wasnt a particularly huge volume day in the markets; but it was a particularly heavy volume day in some important stocks; namely C, BAC, WB, GE, AEO, JCP, DHI, KBH. All are breaking short-term downtrends and doing so on heavy volume. If that wasnt enough, this is happening in the context of generally poor news, earnings and economic data. Short term trends must become constructive before intermediate trends do so and so on with intermediate and long term. The action has played out very much as we expected and charts are starting to support the idea that the worst is likely to be over for financials shares.

We continue to think when its all said and done, we are likely to be talking about an otherwise greater economic and equity market disaster being averted as a result of aggressive coordinated policy responses. I also think that the huge rate cuts instituted by the Fed are sure to help most banks and brokers, many on the brink of disastrous option ARM resets and also grease the wheels of the credit markets and allow libor rates to gravitate toward U.S. rates and thus help even more.

We think that the banks with extensive branch networks and deposits are helped most, while those with substantial credit card operations like B of A get an added boost and guys like C and JPM that have all that and then a good deal of mortgage exposure may be helped most. Relative to what would have otherwise been the case that is. We don't mean to imply that everything has been fixed in one fell swoop.

Banks with Liability sensitive balance sheets should be helped most. Funding costs/costs of funds have declined significantly (almost overnight). Banks with hefty amounts of spread income are sooner likely to see improved net interest margins and net interest income. The boost to 2H08' profitability will go a long way toward improving industry capital ratios and putting banks and borrowers on the margin in position to refinance and restructure loans is big. Rate sensitive equities are getting a lot of help and reflecting it.

The next few trading days will be telling. Several Banks, Retailers and Homebuilders are now 40-45% off their lows; impressive! Furthermore, many of the leading banks, builders and retailers are approaching difficult technical levels. From a technical perspective, a rest is in order as bears put more shorts on and anyone fortunate enough to capture a good part of the recent move cashes some in. Thus, I'm expecting a pullback in the next few trading days. We'll be looking to get long some quality as this happens.

Fed Schmed - Don't bring a knife to a gunfight with The Fed

Investors can't help but speculate on the various if-thens associated with what the Fed does and says and what an investor or trader should or shouldn't do in response or anticipation. The conventional wisdom goes like this: Since the bond market is discounting nearly a 100% chance of a 50 bps cut in the Fed Funds target rate, anything less would be disappointing and lead to a market sell-off in both treasuries and equities.

So most probably expect that 50 bps would be good for stocks and bonds, 25 bps bad and no cut a disaster. That may very well be the conventional wisdom; but it doesn't mean its true or you should trade or invest accordingly. So what should you expect a do or not do? The short answer is (whether you are bearishly or bullishly inclined) don't bet on instant gratification.

Alphatimer is of the opinion that this is not a good market for momentum trading either on the long or short side. No good for long momo because the major market trend is anything but up and not great for the short side because the rush to coordinated policy actions that we seen in the last two weeks is tantamount to market manipulation (in support of the long side) of the highest order. Instead of allowing an enormous amount of bad trades meet the rightful comeuppance, the Fed, Congress, and the White House are pulling out all the stops to bail out banks, brokers, tapped out consumers, over-extended homeowners, and credit insurers.

We think such concerted policy actions, whether you agree with them or not, are powerful forces which shouldn't be underestimated. It looks like we are on the cusp of the mother of all bailouts and we do not want to be on the other side of that trade. That's not to say that all is well again and the problems in the real estate market, credit market, derivative market or most importantly job market are all solved overnight.

There's little doubt that economic activity is contracting and that has reflexive implications that can only be reversed in time. And there's little doubt that the next 3-6 months of economic data are likely to be negative. However, we do think that enough is being done in terms of reducing market rates to help banks earn much better spreads and thus be better positioned to grow balance sheets sooner rather than later instead of shrinking balance sheets and lending less. Market rates would also soon decline sufficiently to allow homeowners to refinance and thus pre-empt a significant amount of foreclosures and billions more in credit derivative losses. If the Fed can only figure out how to bailout credit insurers, most economic fires will have been put out.

To the extent that it matters, we think it a safe bet to assume that the Fed knows that it must inspire confidence. That being so, we think that whether we get 25 or 50 bps; we are very likely to get re-assurance that the Fed is willing and able to cut more if/when necessary (which wouldn't be as bad as some think). Pundits might very well rush to criticize Bernanke and the Fed again, and highlight the economic problems. Keep in mind, however, that the market will not track coincidental to economic data; instead the market will look ahead.

In that context, this market quickly becomes a stock pickers market for shorts and longs. We expect no big move up or down in the indexes from here. We expect the negative market effect to lose its influence sooner rather than later. Therefore, we expect the short side loses the wind at its back. At the same time we also expect earnings disappointments to put a lid on potential upside. Its also quite possible that earnings disappointments may be shrugged off as the market looks forward. Either way, we think the next few weeks and months will be tough on bears and bulls alike.

If we are correct about the odds favoring either successful retests of recent lows or a basing process ensues, then this market will frustrate most. This looks like an environment where value investing thrives. We continue to think there is a good deal of value in the market. Long term value investors should look for opportunities to buy pullbacks in out of favor, absolute values with solid operating and financial performance. companies generating solid returns or well positioned to improve returns and free cash flow generation.

Another Card from the Dealer

Put your helmet on as we watch the next few cards the dealer deals.

With Asian markets falling hard post the U.S. market slide Friday, it's reasonable to expect a rough open for the U.S. markets whether or not Asian markets close well. An impressive intraday rebound in Asia would certainly be constructive; nevertheless, 4% plus slides in developed market indexes are also certain to inject doubt that any type of bottom may be imminent.

After the bounce we saw on Wednesday, Thursday and Friday morning, one should expect some retracement. How substantial and vigorous that might be may or may not have the implications market pundits are likely to posit. Given the substantial fear in the market, bearish technicals and negative headlines; it makes sense in my opinion to expect action more typical of a bearish continuation pattern (ie. heavy volume, seller dictated action) which puts the recent lows in jeopardy.

With the U.S., Japan, and Europe seemingly on the fast track to recession, markets are apt to begin questioning how China and a few others could buck the trend. Although no key market questions are likely to be resolved anytime soon, we do get a lot of economic data this week. New home sales, Durable Good Orders, Advance GDP, FOMC's Policy Statement, Chicago PMI, ISM and Payroll data all get released this week. Volatility is sure to remain elevated through Friday.

For better or worse, the big question then becomes whether or not recent lows hold. For clues on that score, I suggest we watch the action in individual names rather than the Dow, Nasdaq or the S&P500 as I'd expect a rather bifurcated market - one in which the financials, and techs pullback hard initially, and eventually hold recent lows, while cyclicals and those viewed as most levered to global growth take it on the chin.

This is not going to be an easy week to trade whether you are bullish or bearish. While all the madness ensues, I'll be observing how the market plays the economic hand its dealt and double checking my shopping list as I prepare to go all in. If you're holding bad cards, I again suggest you fold quickly and look to play better cards.