What's Next for the Stock Market?

By James Kostohryz  AUG 03, 2011 12:45 PM

In the coming months we could see some interesting buy opportunities, assuming the global economy doesn't collapse.


In a post to the Buzz & Banter, published Monday afternoon, I wrote the following:

Putting all of this together, my take on the most likely scenario going forward is the following: After a relief rally associated with the passage of the debt ceiling legislation today or tomorrow, I believe that the market will tend to drift down towards the 1250-1260 support band in the next couple of weeks. I believe that if the market visits that support area, there is a better than 50% probability that it will violate it. The reason is that I think poor economic data pertaining to July and released in August may weigh heavily on the market during the entire month. If the market violates this key support band around the 1250-1260 area, at that point we would dealing with the specter of a potential cyclical bear market.

It didn’t take long for that scenario to play out, did it?

As a result of this move I sold the remainder of my SPX put positions earlier today with the S&P at around 1,235. I remain long VXX, as I believe that implied volatilities are still low.

So, the question is: What happens now and what to do going forward? A few thoughts:

  1. Europe is a major key. The woes of the Old Continent are back on the front pages. The bond market is taking things into its own hands and sovereign debt yields for Spain and Italy are spiking towards levels which, if sustained, will catalyze a major crisis with global implications. Thus, it would not be wise to buy stocks anywhere in the world until one can gain an insight that concludes things are going to be brought under control in Europe.

  2. The US market has no positive economic catalysts in August or September. It is now clear that July was a terrible month for the economy, driven by the uncertainty surrounding the debt ceiling circus. Thus, all economic data released in August is bound to be bad. With the market declining precipitously in August, and all of the bad data released, the September data will probably not be pretty either.

  3. Earnings season is over. No positive earnings catalysts are in sight. If anything. It is more likely that there will be some earnings warnings and downward revisions associated with the July slowdown.

  4. The Fed's hands are tied. One silver bullet left. QE3 doesn’t really make much sense with 10-Year US Treasury Bond Yields (^TNX) at 2.6%. QE3 would only make sense if global money markets and/or longer-dated fixed income markets became tight. Right now, there is plenty of liquidity in the system. It is just that the banks have it all deposited as reserves. Indeed, that is the one silver bullet the Fed may have; to lower the interest rate paid on reserves to 0%. That could incentivize banks to place some of that cash in the money markets.

  5. The US equity market is technically broken. The 200-day moving average has been violated decisively and the strong horizontal support at 1,250 on the S&P 500 was violated.

  6. Commodity prices are way too high. Given the global macro risk environment, commodity prices ranging from oil to copper are soaring. The prospect of a very severe commodities correction is high as poor economic data is released around the world, with a particular emphasis on China.

In the sort of overall scenario depicted above, it is hard to see how stocks could make much headway in August.

A potential area of support lies in a wide band between roughly 1,180 and 1,210 on the S&P 500. Whether that area will hold depends on the various issues cited above. Furthermore, the sooner the S&P 500 probes this area during the month of August, the less likely it will hold.

Assuming the global economy does not collapse (and the US economy is left as the only one standing), an interesting play could be to short long-dated US Treasuries if and when the 10-year yield gets to around 2.5%. This level of long-term yields is not sustainable. Either the global economy stabilizes and US growth picks up to some level that enables the Treasury to sustain interest payments, or there is going to be a general economic collapse. In that case, the fiscal situation in the US will become unsustainable. In either case, from a base of 2.5% or below, long term Treasury yields will inevitably go up.

Gold? No thanks. It’s overvalued relative to just about all other potential inflation hedges. This doesn't mean it cannot go higher and become a massive bubble. Indeed, virtually the only argument going for gold right now -- as gold bugs remind us on a daily basis -- is that it is not yet as big a bubble as it was in 1980. If you want to speculate on the emergence of a gold bubble of that magnitude, be my guest. But make no mistake, with the price of gold where it is right now relative to the CPI basket, real estate stocks, and other assets, and considering it is trading at twice the all-in marginal production cost, gold is moving into bubble territory. There are much better long-term options available if you're looking for inflation protection and/or a safe haven asset.

I am also drawing up a list of high free cash flow yield stocks with pricing power -- preferably paying a high dividend yield. These sorts of stocks will become the top income-producing and inflation-protected assets of the next decade. The usual suspects such as AT&T (T), McDonald's (MCD), and Pepsi (PEP) will be considered, along with techs such as Microsoft (MSFT) and Apple (AAPL). I will update readers on any purchases in this vein.

In sum, the market is in for a rough August. I would consider shorting any substantial rallies of 40 S&P handles or more (perhaps on QE3 rumors). I would also look for potential buying opportunities with the S&P 500 at or below 1,220, provided that it can be determined that the global economy is not going to melt down. Finally, 10-Year Treasury Bond yields beneath 2.5% are probably not sustainable, and if they materialize, could provide shorting opportunities.

Position in VXX

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