Will Shallow Hal keep buying the dips?

For those of you who may not know who “Shallow Hal” is, allow me give you some background. A few years back there was a movie called Shallow Hal. A humorous movie which featured a young man who was very shallow in his thinking about the women he wanted to date. In some interesting twists this young man falls in love with what he thinks is a gorgeous girl. The twist is the girl is actually far from gorgeous in a physical sense and everyone except for Hal sees this. The movie has become a metaphor for the markets with Wall Street acting as Hal and the markets being the girl.

For the last few months Shallow Hal (Wall Street) has been eager to buy any dip in the market in the hopes that recovery within the economy is on the horizon and their beauty will shine. Hal has pushed aside any of the ugliness within the economy actively willing to ignore the potential risks in an effort to chase performance. The girl in our story, the economy, has seen stabilization and is being supported with vast amounts of liquidity from the government but is far from ready to enter a beauty pageant anytime soon. The dichotomy makes for a tricky setup as expectations rule the roost.

Last month we touched upon the effects expectations have on the market. As we move into October, which historically tends to be the most volatile month for markets and has been ever since we were a Gregorian society that traded herbs and food in the fall after harvest, we wonder if Shallow Hal will step in and buy any dips that may happen. So far as I write the first day of October has been a shocker with a 200 point drop in the Dow. This maybe nothing as it was in September when we saw a similar sell off the first few days of the month on the back of economic reports that were below expectations to be answered by widespread buying from Shallow Hal. The sell off here in October could turn out to be the same, however, this month there are some differences that could play out to create a turning point in markets which I’ll cover in the next few paragraphs.

As the market has moved higher stocks have become more expensive. There is a very large group of investors – mainly mutual funds that look for value – which use valuation models (how much a stock should be priced according to its earnings) to determine how much risk they will place in their portfolios. As stock prices have risen and revenue and earnings of companies have declined, this group of investors have greater difficulty finding stocks they want to buy. The result is they wait until prices come down in a market correction or earnings increase before they begin applying more money to markets. This slows the pace of buying from this particular group and as the market moves higher this group of investors begins to participate less. The result is less buying pressure and less volume in the market which can help cap the recent rally.

The above group of investors which work on valuation models are using what we call fundamental analysis. Just as there are a lot of fundamental investors there are a lot of technical investors. These guys work less on fundamentals and more on charts and things like Elliott Wave Analysis (check out www.elliottwave.com for some interesting research) Fibonacci numbers and market cycles to help determine their moves. This group of investors have the belief that what we have seen since the March low is a bear market rally which will eventually fail with greater declines being made in 2010 as Shallow Hal starts to realize his prized girl isn’t so pretty after all. Many in this group have had a price target of 1100 on the S&P 500 as a target that would cause a reversal in the markets. We reached 1080 last week and have reversed sharply from that point. This group also sights that there are 4 market cycles that were scheduled to top between September25th and October 5th of this year. The last time these 4 cycles topped we saw a correction in markets and so far considering how October has started they may be able to put another feather in their cap.

At current market levels the market appears to be priced for perfection with recovery in the near future. This creates a slippery slope if earnings, which start being announced next week, are not what they are expected to be. In addition to earnings we are beginning to see a shift in the mindset of Wall Street as recent economic reports have not been meeting expectations. This shift is starting to show the thought process that things may not rebound in the economy to the level the market has priced and is causing some investors to take profits and others to take a wait and see approach to applying more money to investments.

It’s been quite a while since all three factors- valuations, technicals and expectations have converged. The big question is will this convergence create a short term correction in the market or become something larger. If and when a correction is seen the strength of the sell off will tell us more as to whether we should be buying the dip or staying far away. If we were to make decisions assuming there is no change in Shallow Hal’s behavior then we would say the correction could be a good buying opportunity. As always, we will keep you informed as things unfold.

We have received a lot of positive comments on the layout of our newsletter when we break out the pillars of the markets so we will continue to do so with a brief forecast of the Dollar, Interest Rates, Gold, Oil and the Equity Markets below.

Equity Markets
Last month’s letter spoke of weakness in the early part of September giving to strength in to the end of the month and beginning of October which is what was seen. The strength appears to have ended slightly short of our early October time frame with the equity markets showing signs of selling off the last few days of September and the first of October. Moving forward we expect to see the markets continue this weakness for the next few weeks with the possibility of seeing the market reach as low as 970 on the S&P 500 (currently at 1025). That 970 level seems to hold the key to longer term expectations as if that level is breached there is a possibility we could go as low as 850 before finding solid support. On the flip side if 970 holds any further selling then we could see markets increase into the tail end of the year with a run back towards the recent highs seen at 1080. For lower risk investors who rode the market down to March and have seen a decent recovery this is a good place for you to reduce your exposure to stocks and reassess from the comfort of safety.

From Last month’s comments : Recently the hurdle for Oil has been the 75 dollar mark. Each time we have reached that price area Oil sells off quickly. Two factors affect Oil prices – consumption and the dollar. Considering oil has been unable to get over the 75 dollar mark it appears the market believes there isn’t enough demand within the global economy to push prices higher. It appears for the near term Oil may be stuck in a range between 65 and 75. For longer term investors it is probably best to watch this market from the sidelines until a more predictable pattern develops.

There is little to add to this for this month except that the hurdle for oil has now become the 70 dollar mark and Oil continues to make lower highs on each rally which is typically not a good sign.

Few assets have had as much press time as gold with everyone speaking about the possibility of inflation with the government printing money as it has. We continue to remind people the reason the government is printing so much money is to fight deflation. We do acknowledge that there could be inflation in a few years but it is hard to see inflation when unemployment is at 9.8% and more and more people are taking pay cuts. The biggest mover for Gold has been the dollar as most traders are using Gold as a way to hedge the dollar. It is our belief the dollar will tell us where Gold will go. As of now Gold has had a struggle to stay above $1000 an ounce and until there is a defined rally with volume that takes Gold above $1030 an ounce we are expecting the prices to decline in the near term.

The Dollar
From last month’s comments : Currently the dollar appears to be attempting to form a bottom. The recent action in the dollar suggests that it is preparing to stage a multi month increase which could put some pressure on the stock markets. In the short term (next few weeks) you could see increased volatility within the dollar with one last decline before it begins a longer term growth phase. For those of you interested in watching this you can use the symbol UUP. There is little to add to this other than in recent weeks the dollar has held its ground which adds weight to the previous comments.

Until next month enjoy your Halloween.

Colby McFadden


**The opinions expressed are those of Colby McFadden and Quiver Asset Management as of 10/1/09. These opinions are subject to change due to market and other conditions. Past performance does not guarantee future results.