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August 9, 2006

Bulls See the Light

I have to admit that a big rally this morning was one of the last things I expected to see in this market, despite the excitement roused around Cisco's report. The amazing aspect of the Cisco reaction was that people got excited solely by the revenue figure, which was reported 21% above a year ago. Given such a surge in sales, along with the fact that Cisco repurchased 139 million shares, one would think that profits rose substantially, correct? Nope. They were flat, and cash flow actually declined. But John Chambers & Co. raised guidance, and the shares surged... never mind that they are notorious for raising and missing guidance.

A more telling development was put forth by Countrywide Financial, which reported a steep 19% drop in July mortgage loan funding. Its shares were pummeled, and weighed on peers such as New Century Financial and Novastar. Toll Brothers also became another in a long list of home builders to have now reduced their current-year forecast twice.

A quote given by Robert Toll during the earnings conference call is worth noting:

"It is the first downturn in the 40 years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors. Instead, it seems to be the result of an oversupply of inventory and a decline in confidence: Speculative buyers who spurred demand in 2004 and 2005 are now sellers; builders that built speculative homes must now move their specs; and nervous buyers are canceling contracts for homes already under construction. The resulting excess supply has exacerbated the drop in consumer confidence, which first appeared last September, that was already a drag on new-home sales."

I don't know about you, but to me, that seems like an awfully good description of a bubble bursting. The decline of housing is an economy-wide event with direct implications on the consumer. Cisco's report, even if its numbers can be believed, is more likely company-specific. Nevertheless, bulls took the Cisco news by the horns and renewed their hopes of a second-half spending boom.

This morning's pop certainly chased some shorts out of the market, but the meltdown in the housing sector reminded me that all the reasons I am shorting are not only still here, but unfolding in front of our eyes. Perhaps foolishly, my skepticism spurred me to buy more puts in various issues. I say "foolishly" because my short positions are already huge, so despite the fact that my moves were vindicated as the day wore on, they may not have been the most prudent action. My tolerance for risk is high, though, and my protective measures, tight.

The early action saw yet another battle over the 1280 region on the S&P (see Post-Pause Prospects, published last night in my Macro section). The bulls attempted to instigate a short squeeze by rapidly pushing the index above that disputed level. Then they ran out of steam and ultimately got caught in a bull squeeze. Equities headed straight down through the remainder of the session, exiting just above the low of the day. I expect tomorrow to be bloody.

Bulls have an innate tendency to always be bullish, even in the face of defeat. The light they saw today was not a product of sudden lucidity, but rather that bright light leading the bull market to its afterlife.

Disclosure: Short NEW; Long CFC, NFI Puts

 

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