This Bear Market Rally Will Set Up Put Buying Opportunities

Yesterday, the stock market staged its best one-day rally in five years and it set up option trading opportuniies. The Fed took a new approach to solving the liquidity crisis. They are prepared to lend up to $400 billion in Treasuries to financial institutions that pledge AAA rated mortgages as collateral. This is not a mortgage bail out. The government is simply offering a solution to a short-term liquidity squeeze. As cash is needed, financial institutions can't sell their mortgage holdings because they are relatively ill liquid. The demand for mortgage paper is very low because the foreclosure rate is rising. Consequently, those firms that have attempted to unload those securities have done so at severely depressed prices. This maneuver by the Fed will give financial institutions access to much-needed capital without having to dump their mortgage portfolio. However, this does not address the larger issue, Americans own more home than they can afford. The government is not taking responsibility for any loan defaults. That responsibility rests with the financial institution. As the unemployment rate rises, delinquencies will push higher and the foreclosure problem could spread beyond the subprime and "Alt-A” loans. In July, the greatest number of mortgages will shift to in adjustable-rate. Yesterday's rally was strong and I warned readers two days ago that bear market rallies can strike at any time and they can extend much farther than anyone thought possible. Yesterday morning, I suggested that the knee jerk rally might run out of steam by late afternoon and I was wrong. Short covering set in and the market shot higher. For a number of days, I have been saying that if the market could stage a huge rally before it reached the SPT 125 level, there was a chance for a sustained bounce. Unfortunately, yesterday’s rally was aided by the Fed. I wanted to see natural (unaided) buying and consequently, I am skeptical of the move. In the chart, you can see that the market still has to get through the down trend line. Then it will have to take out resistance at SPY 139 in order to gain investor support. In light of deteriorating economic conditions, stiff inflation and a falling dollar, I don’t see that happening. Next week’s FOMC would normally be bullish given the expectations for a rate cut. Fed easing has not solved the problem and any positive reaction will be short lived. Fear of the unknown dominates trading. No one knows the depth of the mortgage crisis and the transparency is very poor. I believe that this rally is a shorting opportunity. Wait to see if it can follow through with another few days of buying. The higher it gets before it stalls, the more compelling the short. Be patient and scale into stocks that are in a downtrend and were not able to rally yesterday. Healthcare is a good place to look along with financials. Once a capitulation low has been established, the market normally rallies strong for 2-3 days. We are not seeing that this morning. If the market breaks below SPY 132 today, it will resume the downtrend and retest the lows in the next week. If the market rallies, another wave of short covering could be sparked. Take your lead from the action during the last hour of trading.

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