Nervous Trading Ahead of the Unemployment Report – Favor the Short Side.

July 1, 2008

Yesterday, the market staged a nice rally for most of the day. It was helped by end-of-month fund buying and end-of-quarter window dressing. By the close, sellers were able to push the market back down to unchanged.

This morning, nervousness from the financial sector weighed on the market. Rumors that Lehman might have to put itself up for sale circulated and the S&P futures were down 13 points before the open. Today’s low came very close to touching the double bottom made in March.

The ISM manufacturing number exceeded expectations and factory activity rose to 50.2 in June. That piece of good news sparked a small rally in an otherwise quiet market. Tomorrow, factory orders, the ADP employment index and oil inventories will be released. The ADP employment index tends to exaggerate employment. Any rally off of that number is suspect. Oil is almost oblivious to the number and continues to climb. Israel continues to threaten an air strike on Iran and that is pushing oil higher. We have reached the “tipping point” and energy prices are weighing on global interest rates/economic activity.

The next two days are likely to be nothing more than pre-holiday position squaring ahead of a big number. The Unemployment Report on Thursday will make or break this market. If the employment rate continues to deteriorate, the market will break below major support at SPY 126. Conversely, a better than expected employment picture will spark a short covering bounce from an oversold condition.

I am playing the report from the short side. I am short restaurants, retail, defense and tourism. My position is hedged with long positions on energy stocks. I am not perfectly hedged and my bias is to the downside. The market could go either way after the number and I am most comfortable selling rallies at this juncture.

For today, look for choppy two-sided trading action with a negative bias. I believe traders will error to the side of caution ahead of Thursday’s number and I expect to see selling pressure.
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