October wasn’t so scary but it might be giving us some bigger clues

Last month we asked the question of whether or not Wall Street would continue to buy the dips as we move into the fall season. You may recall we started the month of October with a one day 200 point drop in the Dow. This 200 point drop was answered with buying as Wall Street continued its habit of buying any dip the market provided. By the second week of October the market stretched itself to make new highs for the year causing many to wonder if October would not live up to its reputation of being one of the most volatile months. However, October didn’t let us down, while the month started with buyers coming in to snap up stocks it seems some of the other factors we mentioned in our letter from October came into play.

As the month progressed the market seemed less willing to bid up stocks on the recent earnings reports. We noted three factors which could put a lid on the market’s rally in the near term. Our concerns about Valuations, Technical’s and Expectations turned out to win over by the end of the month with weakness and selling seen in the last week of the month causing the markets to end October with a negative return.

Increased Volatility as the “Hope” trade gets blown in the fall wind
The most notable observation must be the increase in volatility seen in the last week of the month with the market running up 150+ points on the day GDP was reported to be 3.5% only to lose 250 points the very next day as the positive sentiment turned into skepticism about what we can expect in the future from the economy now that many of the stimulus programs are set to expire.

The market now stands in a precarious position. It appears that the “hope” trade has lost its steam and no longer will the hope for an improved economy be enough to propel markets. In this quarter earnings reports many companies were punished badly if they did not meet lowered expectations and even the companies that did meet the expectations would see their stock price jump for a day only to lose all those gains in the days to follow.

This is a notable change from July and August and should be respected as the reaction to news is more important than the news itself. Within the recent volatility there seems to be some significant underlying changes happening within the technical’s of the market which are pointing to the increased probability that we will see a 10-15% correction in the markets within the next few weeks.

The big question is: If this correction does play out is it a buying opportunity or the beginnings of a larger multi month decline?

At this moment it is difficult to tell. If and when this market corrects downward the style in which it does so will give us more information. As of this moment it appears the correction (if seen) could take the S&P500 down to the high 900’s (968-987) area which could be a good entry point for anyone who has been waiting to buy into this market.* If the selling stops in that area we could see the market rally back to the recent highs by January of 2010. If you decide to do such a thing it would be prudent to use 950 on the S&P as a stop loss point as a break below 950 could open the door for a decline to the 870 area and would indicate the recovery everyone has been hoping for will be more fragile.

It is important to remember that there are always two sides to each coin and if a correction is not seen in the next week or two then we could see markets make a move to new highs. While we believe this is unlikely at this moment considering the negative technical’s within the market we must be aware of its potential. If this were to happen there is a massive amount of resistance in the 1120-1130 area of the S&P500 which would most likely put a lid on the rally. Because of this limited upside potential and greater downside risk it is best for lower risk investors to be patient and wait to see what plays out. If you are an investor who has ridden the market down earlier this year to get some relief from the recent rally we will repeat ourselves as we did last month and say the current market levels are fair places to reduce risk and build up on cash reserves.

The Tale of Two Economies
On the economic front the news has been improving. Credit markets are operating like there was never a problem with many new issues of debt being issued (this is good as it helps companies finance their operations at low rates), leading economic indicators have seen over 3 months of improvement, manufacturing as well as housing numbers have stabilized with the last few months showing slight improvements and GDP has turned positive. The only 2 flies in the ointment have been employment and consumer sentiment, neither showing any significant improvement over the past few months.

So it appears we have a tale of two economies. On one side we can see that all the government stimulus with cash for clunkers, the first time home buyer credit along with the TARP and TALF programs have saved the day. These programs seem to have prevented this recession from turning into a depression so far. This is good for investors because they can begin to take some risks knowing the overall market place is secure. However, this does not eliminate the risks that exist with 10% unemployment and a consumer that is strapped with significant debt along with an aging population that will naturally invest less as time progresses.

As a result unless there is a significant positive change in the economy we can expect financial markets to begin a sideways trading pattern similar to what was seen in 2004. Within this sideways motion there will be many opportunities and most likely a decent amount of volatility. This will make it very difficult for traditional investments like mutual funds to see decent relative performance as they need a market to trend higher in order to appreciate.

In an effort to help with this we started forecasting the main pillars of the market to help investors gain a better insight in what is happening with respect to stocks, the dollar, interest rates, gold and oil. Below we have updated our comments from last month.

The Dollar
This month we will begin with discussing the dollar as it seems to be the main driver in markets. The dollar has proven to be the focal point of this year’s rally for every time the dollar has declined the stock markets have increased and vice versa. The reasoning behind this is that the markets have become commodity driven. When the dollar declines in value then all commodities (gold, silver, oil, food) tend to move higher pushing the stocks associated with these commodities higher as well. In addition, many of our companies such as Intel, Pepsi and any other U.S. corporation doing business globally receive a bonus to their earnings with a weak dollar. In a nutshell a weaker dollar is good for company earnings and stock. I know this seems counter intuitive to think a weakening currency is good for the market but it is how the market is designed.

Just as a weakening dollar helps the stock markets a strengthening dollar could be the death to this recent rally as much of the late month volatility was in response to what appears to be a bottoming of price in the dollar. We noted in the past 2 months of letters we expect to see the dollar surprise investors by making a multi month low and seeing strength into 2010. With the recent action this appears to be happening and could be the creator of the possible correction we mentioned earlier in this letter. For those who want to track the dollar you can use the symbol UUP which is an exchange traded fund that tracks the dollar’s performance.

If the dollar does continue to see strength you can bet on weakness in the Gold markets. Outside of that simple analysis there is little to add to the forecast on Gold.

In last month’s letter we noted that oil had been making a series of lower highs and commented that this is a negative sign for the price of oil. That process ceased to exist in October as Oil finally broke above 75 dollars a barrel and peaked just above 80. From a technical view point it sends a buy signal to anyone interested in owning oil. A word of caution to those looking to buy oil on the recent action to use 75 dollars as your stop loss as the fundamentals of the oil market still look pretty bad with vast amounts of inventory and the potential for the dollar to see strength. For now, as long as 75 dollars a barrel contains any price decline Oil appears to be a buy.

Interest Rates
Interest rates continue to be stuck in a range as noted in past letters. However, now some patterns are beginning to play out which gives us the impression interest rates could be on the rise. If this is seen it could put additional pressure on the economic recovery as rising rates could have a negative effect on mortgage rates and the purchase of homes. We believe it will take another month or two for the interest rate market to begin to break out of the sideways range they have been in for the past few months. This next week may provide additional clues as we have a Fed meeting which takes place on Weds Nov 4. We will update you as this unfolds in next month’s letter. For now we issue a word of caution to anyone interesting in investing in bonds or bond funds as if rising rates are seen this will decrease the performance of those investments in the near term.

The Stock Market
There is not much to add from our opening comments in regards to the increased probability of a near term market correction. How this correction plays out will tell us if the Bears will be right in their analysis that markets will slide south in 2010 and 2011 as we deal with the structural problems in the economy with high unemployment and reduced spending by a debt strapped consumer or whether the Bulls will come out ahead supported by economic stimulus and the government’s determination to get the economy back on track. Regardless of the outcome we will continue to update you and alert you if there are any major changes that can or will affect your longer term investment goals. For the near term we urge you to use caution and wait for a decent decline prior to putting new dollars to work in the markets while not forgetting that there are still many long term opportunities which are beginning to play out.

Until next month enjoy the fall weather and have a great Thanksgiving.

Colby McFadden


*The opinions expressed are those of Colby McFadden and Quiver Asset Management as of 11-2-09 and are subject to change due to market and other conditions