Tuesday, March 31, 2009

Bull Run Falls Short

Bull Run Falls Short
End of Month Report - Part 1

Major Stock markets staged a remarkable comeback in March with the Dow Jones Industrial Average rising to 7,608, up 545 points or 7.7%. The S&P 500 rallied 8.5% to 797.87. While the gains were impressive, the S&P’s failure to close above 800 and the Dow’s inability to break above a major resistance level of 7,676 leaves doubt that the downtrend has come to an end.

I mentioned in previous writings this month that Volatility Levels are starting to drop. This is generally my first signal to anticipate a potential stock turnaround. The second step would be to look for a basing pattern in the charts.

With the Dow at least rallying this month, I will look for one of the following two scenarios to play out in April. Either the market will drift, potentially setting up for the three month test of the February lows, or the market will bounce down from the 4-month moving average and make new lows.

The following graph illustrates Scenario #1 …

SCENARIO 1: The three-month test of the low scenario might be the best possible outcome. Should the average remain stable, closing next month little changed, the price could rest right on the four month moving average. Then in May, we would be closely watching to see if the Dow could hold the February closing low of 7.062. Should we hold the 7,062 low, look for a long-term rally to begin.

Again, with the volatility indicator reversing, it’s very possible that price will drift sideways. While the above scenario could be the best scenario a variation of this is that the market will continue to drift sideways until it meets the ten month moving average (the red line). It could take another six months of sideways action to meet the 10-month moving average.

SCENARIO 2 is not as friendly and more probable considering the uncertainty that surrounds the banking system, auto industry and other sectors of the economy. As I have mentioned several times in the past month, markets almost always try to come back and test key areas of support and resistance. By not being able to maintain above the 7,600+ support level, chances are that the market will sell off in April, making new lows.

The battle for supremacy was fast and furious as expected. Like a battle between two prize fighters, the Bears were getting beat badly as the Bulls pushed the Dow towards 8,000 last week. The Bears though were not giving up and staged an attack starting on Friday, pushing the Dow down into the 7,400 area! The Bulls came back today, pushing the Dow up 200 points, above the support level.

In the end, the Bears again took charge, driving it index down below 7,600 at the market and end of the month close. Only last minute settlements brought the Dow above 7,600. There truly was a monumental battle here between the Bulls and the Bears. The Bulls could not hold their ground in the end. I'm sure that we will quickly learn whether the Bears will remain in control. As I write around 8:50 pm, already Dow Stock Index Futures are trading down to the 7,500 level.


Believe me, I would love to be a fundamental analyst. But accounting data seems to be so manipulated, numbers massaged, footnotes everwhere. Who can tell what is going on? And if you wish to analyze various segments of most corporations, that data does not exist in public information. I fear that fundamental analysis will take another hit with the proposed Mark-to-Market (MTM) changes. What is MTM all about?

MTM is commonly used in the futures and other derivatives markets. At the end of each trading day, gains and losses are settled up. If you have a position that gained in the day, money from the loser would flow to your account. If you were the loser for the day, money would flow out of your account. If you don’t have the money, then you will get worried calls from your broker asking you to please, at your earliest convenience (by the end of the day) to add funds to your account or the position will be closed out.

The big reason that MTM is causing so much concern now is because many of the mortgage based instruments cannot be valued because the housing market is so volatile. If you can’t value the assets on your books then how can you determine what the bank is worth and how much cash they need to protect themselves and their depositors. What the banks are proposing is that changes be made in the accounting standards to allow them to value these “value-less” assets at face value instead of the current market value (which is very low). This would allow banks with very risky positions to look great on paper. Another blow to those who really want to understand the fundamentals. Without real transparency, is it worth it to buy bank stocks in the future?


The government could be supporting the MTM accounting changes for other reasons as well. Recently, the Federal Reserve Bank announced that they would be aggressively buying long-term treasury notes and bonds in an effort to lower interest rates, helping to bring mortgage and other credit rates lower. The problem with this action is that the Fed is buying Treasury securities at very high prices and reporting them on their balance sheet to support the integrity of the US dollar. What would happen though if interest rates do advance sharply? Bond prices move inversely to interest rates so if rates advance, bond prices would fall. And the longer the maturies are, the more volatile the price movement would be.

It’s not inconceivable that bond prices could fall 25%! Imagine what impact that could have on the dollar from an integrity standpoint. If the assets backing the greenback decline in value (or become worthless as could be the case for some “toxic assets” they are holding), foreign investors could exit their positions in the dollar en masse! BUT WAIT! No no no! We don’t use the mark-to-market any longer. Our devalued investments can still be valued at face value since someday, we expect that they will reach maturity and we will get all of our money back. Will investors continue to be deceived? Or perhaps there is just no place else to go with money.

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