“When would you short the markets?”

NOTE:  This Trading alert was originally emailed to subscribers at Ritholtz Research & Analytics on Tue 9/26/2006 2:28 PM EDT;

This is posted here not as investing advice, but
rather as an example of a trading call for potential subscribers. We
expect to post future advisories in a similar manner — after the call,
but in the correct chronological location on the blog.

Last week, we were asked “What would turn you Bullish?”

This week, we received what is the opposite question: “When would you short the markets?” 

The answer to this question – to both questions, really – depends
upon how much further and how fast the internals decay as the markets rally towards
the May 2006 highs.

This could be a very crucial phase of the market. The next
5-10 trading days may turn out to be a key period that determines the
following few months.

As Markets march higher, we note the short term factors are at
work:

1) This is the final week of the quarter, and with it, “Window
dressing – funds buying more of their favorite stocks to improve their short
term performance. I would expect this to continue for a few more days;

2) The Dow highs are about a 100 points away, and as we have
mentioned previously, I expect them to be taken out – likely before the week’s
over.

3) Pessimism continues to be thick; The one way to guarantee
a correction will not occur is for too many people to expect it.

4) Some sectors may have priced in at least some of the bad
news: Neither Lennar’s preannouncement
of bad news for Q4, nor Home Depot competitor Lowe’s (who sees income at lower end
of prior view) led their stocks lower; Indeed, as of this writing, both are
higher.

5) There is a surfeit of cash in the hands of fast traders; Expect
them to continually chase momentum –until that stops working for them;

6) Technical analysis and intermediate term trend each remain
constructive;

Those are the short term factors; These are up against longer
term issues of economic softening and market internals:

1) The main engine of economic growth – Housing & Real
Estate – continues to decelerate;

2) Market advances have taken place on lower than average
volume;

3) Energy prices have become oversold, and are likely to
bounce upwards;

4) The May highs represent appreciable resistance – the double
top may present formidable barrier; An upside penetration could create a Bull
trap;

5) Despite the rally in the Dow, new highs are lagging,
while the number of new lows are expanding.

6) Less and less stocks are participating in the advance:
Indeed, this table makes it clear that this rally is very Dow-centric, meaning
that it is focused more and more on fewer and fewer stocks.   

Note how close the Dow is to its all time high, while the other indices are significantly further away. This is no coincidence:

Most of the positive factors mentioned above are short term
in nature; Meanwhile the negatives are longer term and structural.

All this leads us to the answer to the question “When would you short the markets?”  

As we get closer and
closer to the May highs, we will look to the internals to scale into various
index shorts. We are not there yet, but we expect we could possibly reach that point sometime over the next few weeks.

Our perspective is to be conservative and patient; We have seen too many bears "treed" and forced into coverage their early shorts;  We would much rather wait until the market is gives us its best signal . .  .