Short ETFs jump, watch for confirmation of US stock market rally ending

The US stock market appeared to take a decisive change of direction last night with the S&P closing under 1,000 points and the Nasdaq under 2,000. Short ETFs jumped, particularly the leveraged variety.

But tonight will be eagerly watched by the shorts for confirmation of a major change of direction – from a bear market rally of 51 per cent to a market correction, at best, or serious crash, at worst.

Beware September

September and October are often bad months for global stock markets, and there is little reason to believe this time will be different. Indeed, the economic outlook remains bleak.

What will happen to US auto sales now that the ‘cash for clunkers’ scheme is over? Governments have only a limited capacity to force demand. Similarly as owners of banks they have no magic to restore profits, only to prevent collapses and then at the cost of preserving institutions that ought to fail and handicapping the others.

My shorting interest is concentrated in the banking sector. The recovery has been far too strong in bank stocks. The reality of the market is that profits will stay low and consolidation ought to be the order of the day. Share prices do not reflect this.

Why should stocks stay up while the economic environment remains weak, and could well deteriorate further or at the very least take a long time to recover?

Bank time bomb

Banks are sitting on huge unrealized losses around the world, and it is only the very recovery of stock prices that has eased the pressure on their capital adequacy ratios. As their stock prices fall again this leverage will work in reverse.

Across global industry any modest profit upticks have been largely from cost cuts – job losses mainly – and not from improvements in revenues. How can it be otherwise as global trade has crashed harder than in the 1930s?

In this environment a third down leg in stock prices is to be anticipated and it will likely prove much bigger than anything expected by commentators with a vested interest in talking things up. We will see where we get to by early November but everything points to a big fall now. I think we will get confirmation very soon.

That would also take industrial commodities, including oil, down to new lows. However, precious metals probably have a more limited downside risk as investors will hedge against future inflation and dollar weakness, although the US dollar and bonds will rise first over the next two months.