Following Thursday Bull Trap, Market Falls 261 Points, Earnings Disappoint

Sunday, July 18, 2010

sell ticketsNegative reactions to initial earnings reports drag S&P 1.2% lower for the week

Friday's earnings reports rocked investor confidence as Citigroup (C) and Bank of America (BAC) handily beat EPS estimates but missed on the top line. Economic bellweather, General Electric (GE), missed on both the top line and bottom line expectations. Shares of all three dropped substantially: C, -6.25; BAC, -9.16%; GE, -4.59%. Analysts found significant deteriorations in earnings quality of the banks with the higher earnings coming from asset sales and other one-time adjustments to loan loss provisions.

Even Google (GOOG) produced a rare miss of analyst expectations after hours on Thursday reporting EPS of $6.45 versus $6.53 estimate. Revenues topped but traders still punished shares with GOOG closing down 6.97%.

I do not intend to be a pessimist or an optimist, my clear goal is to be neutral and continually adjust my outlook based on the facts. Right now, there is clearly slowing growth around the world as Europe initiates austerity measures to strengthen their balance sheets and the US pauses after the solid year plus of reflation. The S&P 500's maximum drawdown from the April high to the July 1st intrday low was 17.1% so a significant portion of this story has already been priced in. I was late in recognizing the new trend and I intend to be short only at a price because bear market rallies are fast and furious and far too potentially profitable to stay short and not try to play to the upside.

Overall it was a very disappointing week for earnings. Alcoa (AA) kicked off the season beating expectations and gapping up strongly. Yet, shares of AA are now trading 4% lower as investors sold the news throughout the week. Intel (INTC) had an absolutely blowout quarter but the price action response was extremely poor. INTC closed Friday exactly two cents above its pre-earnings closing price. JP Morgan (JPM), Citigroup (C), Bank of America (BAC) and General Electric (GE) are all down off earnings with the negative aspects taking the spotlight in investors' minds.

Net short position pays on Friday after Thursday bull trap

I started hedging on Monday and went net short on Wednesday. Luckily, I was smart enough to hold my shorts in the face of the huge upside squeeze in the market on Thursday afternoon when it was leaked that the SEC would be releasing a "significant announcement" after the bell. Traders quickly interpreted this correctly as a settlement with Goldman Sachs (GS). GS rallied $6 pulling up the market from down nearly a percent to positive for the day. Goldman Sachs settled the fraud charges for $550 million without admitting wrongdoing but acknowledging a poor level of disclosure. BP (BP) also announced that it successfully capped the leak in the Gulf helping fuel the rally. These are two very helpful developments for the equity market as both these stories were leaders to the downside in this correction.

My largest position continues to be long volatility through the VXX ETF. I think more upside is likely if the first week of earning is any indication of how investors will be reacting to the headline reports. A 20-25% correction would not be surprising after an 80% rally which would equate to another 3-5% downside through the lows of the year. We will see. I have very good prices from Wednesday in SPY and VXX and my stops will be at the respective highs and lows of last week. In general, I am a short-term bear, long-term bull. I will look to cover my shorts and add to my longs over the next couple weeks.

On a side note, Singapore reported 26% GDP growth last week. What an astounding data point!

Shorted some NYSE:GLD on Thursday

I put on a short GLD position on Thursday, the first time I have ever shorted gold. I was heavily long at the end of 2009 and once again last month. But, the correlation had a noticeable change towards the end of June. I have not had a very good interpretation of the reasons behind this decoupling but Keith McCullough of opined on Friday morning that perhaps the selling has been caused by a "sequential deceleration in headline inflation and inflation expectations". Given that one of the many reasons for owning gold is inflationary protection, the last few months of data have showed month-over-month declines in CPI and so fears of runaway inflation are dampening.

Disclosure: Short SPY, GLD. Long IWM, SPY puts; VXX.
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