NOTE:  This Market Commentary alert was originally emailed to subscribers at Ritholtz Research & Analytics on Tues 4/1/2008 after the market close

This is posted here not as investing advice, but
rather as an example of a trading call for potential subscribers.


Markets staged a mighty rally today — the type of rally that is typical in Bear markets. In normal, healthy markets, 400 point days are simply not necessary. They tend to take place in an environment of negative sentiment, risk aversion, and short selling.

Today’s Q2 starter was a similar affair.

However, overall volume was heavy and the up down volume was nearly 10 to one. This suggests that today’s move will have some legs, and we looked at this present surge as a typical oversold rally that should run anywhere from two to eight weeks.

While this move began from a condition of deep negativity. This has quickly been replaced by an excess of speculative optimism. The classic example was the recent Barron’s headline, “Dow 20,000 by year’s end.”

Thus, we do not want to maintain short positions for the next few weeks, as we believe this rally is a classic bear market bounce, and it presents a selling opportunity later this month.

March represented the fifth consecutive negative month for indices. This is only the 10th time that such a streak has occurred since 1928.  Of the prior nine times where five consecutive negative months occurred, only four saw markets higher six months later.  The average total return during those previous periods was  -2.64% after three months.  What this suggests to us is that a five-month streak indicates the early portion of a lengthier bear market.

Buyers into today’s rally who are looking for more than a trade must believe that prices of stocks reflect the full impact of recession. However, this is not truly reflected in the earnings consensus for the S&P 500.  We note that current third and fourth quarter earnings consensus are at +20% (Q3) and +50% (Q4). This hardly reflects anything beyond this a mild brief first-half recession.

Our expectations for the ongoing economic climate will include a much deeper and more prolonged recession than is currently reflected by equity prices.

Intermediate term, the market is also facing several Buzz saws over the next few weeks, which have the potential to take some of the wind out of its sails: We start with Friday’s non-farm payroll (NFP). While we frequently advise investors not to put too much attention on any one datapoint – its best to focus on the overall trends — this Friday’s NFP certainly has the potential to be a major market mover.

After NFP, markets will confront what is likely to be a rather mediocre earnings parade. The season will begin in full force next week. At this point, expectations for the financial sector are grim. Yet despite this negative outlook, it seems that many firms in the financial sector are finding new and clever ways to disappoint: To wit, UBS, Deutsche Bank, and Merrill Lynch. (Kudos to Lehman Brothers for their surprise capital raise. Its worth noting, however, that healthy companies do not need to scrape together surprise $3 billion capital raises).

Outside of the financial sector, we have seen significant weakness in earnings in the technology, retail, and non-exporting sectors.

On top of what is likely to be a mediocre earnings season, the next hurdle for stocks to overcome will be lowered guidance.  In general, CEOs and CFOs have been unusually circumspect regarding both the economy and their firm’s prospects. That weaker guidance will very likely lead to a lowering of earnings prospects for the second half.

And stocks still are not cheap.  A trailing one-year P/E ratio of 18 is reasonable, but hardly what we would expect to see at the beginning of a new bull market.

Lastly, is the surprise factor. There are simply too many unknowns, too much bad paper stuffed into too many dark corners, for us to embrace the markets for anything other than a trade at this time.

Nothing in the overall economy has changed: we are continuing to see an ongoing economic slowdown, characterized by a weak consumer spending, ongoing difficulties in the credit market, a still more abundant housing market, inflationary pressures found everywhere – except in wages and income.

-Barry Ritholtz
April 1, 2008

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