Is It Time to Sell the Bear Bounce?

By Dr. Duru written for One-Twenty

August 12, 2008

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Is it time to sell this bear market bounce? Well, yes and no.

You could barely find anyone to defend the U.S. stock market a month ago. Calling a low at 1200 for the S&P 500 seemed like wishful thinking. A 7.4% bounce later in the S&P 500 and a 10.1% rip in the NASDAQ later, and you can feel the love all over again as the bandwagon bulges. I am loving it too, but I am mindful of the typical and classic warning signs at the tail-end of a bear bounce: low volumes (on the S&P 500), over-bought stochastics, and critical overhead resistance. Over the past 5 days, I have shed longs into this move. I am now looking for some kind of consolidation or correction phase to set-up the next move toward my target of 1440 on the S&P 500. I set this target for this bear market bounce two weeks ago just based on the historical record indicating that since 1962 there have only been 6 years where the S&P 500 did not reclaim the May high for the remainder of the year. This is of course just a guideline that could likely use a whole host of conditions and caveats. This is also a good time to collect my thoughts and review the gameplan. It is too easy to find myself talking out both sides of my neck as I try to keep up with all the volatile cross-currents that are shaking and baking the markets. This refresher is also important because I find myself fighting with the market on certain themes, like buying more gold on Monday and buying the QLD and more S&P 500 last month, and sticking strictly to the charts on others like my bearishness on coal.

In my last piece, I practically salivated over the continued slaughter in commodity-related stocks. After reading "Economists Expect 2008's Second Half To Be Worse Than First" in Monday's Wall Street Journal, I wish I had waited just a little bit longer because some of the data would have provided great background.

I had thought that the consensus was still on the side of a robust global growth story. Such an opinion would make the current commodity sell-off look well over-done. Instead, this article suggests that the consensus actually already expects weaker economic growth both in the U.S. and across the globe. For example, Japan and Germany may already be in recession. Great Britain is grinding slower. China is still struggling to get inflation under control. Why is this important? The U.S. economy may have already hit a recession if it were not for the weaker dollar propping up exports (and suppressing imports). From the WSJ article: "Surging export growth, coupled with falling demand for imports, added 2.4 percentage points to second-quarter growth in U.S. gross domestic product -- marking the largest contribution in nearly three decades. Without that contribution, GDP would have slipped 0.5%." So, it is VERY ironic that the U.S. stock market is supposedly rallying on a stronger dollar. A dollar that is stronger because the global economy is getting weaker and not because the U.S. economy is getting stronger. And that stronger currency could very well provide a negative feedback loop for us given we have no healthy domestic industries ready to fill gaps in international business.

So this is where I have to be careful in sorting out my thoughts and lining up my timeframes. I have zero confidence that the rally in the dollar will be sustained (see my last piece for details). But it does appear that all the current excitement about the dollar could provide a sufficient catalyst to get the S&P 500 to my 1440 target for the year. Not only does the related decline in oil bolster confidence in the domestic economy (especially retailers), but I can imagine that investors sitting on foreign investments are rushing back to the U.S. to make sure they do not miss the "bottom" in the dollar. Big institutions that are scrambling to get out of crowded trades betting on a weak dollar will supply additional fast money and swift momentum. All this excitement could be enough to get folks to forget about the woes of Freddie Mac (FRE) and Fannie Mae (FNM), to place new hopes in an imminent stabilization and bottom in housing prices, to ignore the expanding credit crunch, and to continue to believe that the exploding federal deficit does not matter (or at least it will solve itself). Maybe we get some renewed angst in September and October for a seasonal correction, but anything short of "clear and compelling" evidence of a global recession will fail to stop the party in the face of this kind of momentum. This would postpone any pay-off for gold until at least 2009. OK. I think I am good with that.

I feel the most conflict with regards to commodities. I cannot help but think that commodities across the board are dirt cheap. If we get a global recession, then surely they will get even cheaper. If the dollar continues upward, they will likely get cheaper. The charts of commodity-related stocks are busted across the board and are experiencing serious and ominous technical breakdowns (I have posted several charts in the recent past). But these stocks can get too cheap just like any other stock, and at some point soon, they get extremely compelling, even for just a bounce. At some point, valuations get so low that even small catalysts can reverse the slide in sharp and rapid fashion. Fast Money guest technician Carter Worth is thinking contrarian as well. He is ready to recommend buying oil and agriculture right here. Also on Monday's Fast Money, Jeff Macke offers up the following recommendations: "Potash at $150, Arch Coal at $40, and Agrium AGRIUM at $60." (He also bought the bullish dollar ETF UUP!) Now, why even bother? Well, because at some low point, the risk/reward becomes irresistable. It is all a game of probabilities. The negativity gets so sharp and so loud that it will only take a small positive catalyst to completely reverse everything. If the dollar can rally simply because everyone else is getting even weaker than the U.S., then surely commodities can bounce on, for example, an abiding belief that the globe's economies remain "strong enough" to support prices. And then if it turns out that the original commodity bull thesis remains intact after all (weak dollar, strong demand), then watch out! I continue to watch for entry points but will also maintain "realistic" upside targets.

During my bear market bounce "check-up" two weeks ago, I said that "Overall, I like the action when I take a step back away from the head-spinning daily action." I still like it, but I am managing some risks by scaling back and giving myself a chance to review the over-heated action with fewer chips at stake. For example, I would have preferred to see the oil markets spike on news of the Russia-Georgia war. Instead, there was hardly a blip. I am sure admirers of the complacency quickly pounced on the non-reaction as another reason to buy stocks. I tend to sell complacency, especially in a bear market. However, in the short-term, I am not interested in shifting my overall bias to shorting the stock market unless the S&P 500 breaks down decisively through 1200. (However, I do like the SKF, which triggered on Monday, especially as a hedge. I will also revisit my bias as we approach the May highs).

Be careful out there!

Full disclosure: Long GLD and the S&P 500 in an index mutual fund. Long SKF. Short the QQQQ through puts left over from a small hedge on the QLD. For other disclaimers click here.

DR. DURU®, 2008