Last time out, we claimed “the odds for a decent reversal have clearly risen,” and this circumstance was certainly borne out in the last three weeks.  However, we do not see stocks as out of the woods at all.  The best we can offer is the bottoming phase is still in progress.  The longer this phase lasts, a better base will be built for a more enduring upside.  But this particular rally has been in place for a month and is now in danger of correcting for the short term.  One of our most important proprietary short term indicators will issue a sell signal as early as Monday on a modest downside reversal.  Thus, we believe caution is indicated.

In line with our interpretation of the charts on page four, we are likely in store for a “trading range” environment for the time being, with the best case being a few percent above Friday’s close and no worse than a test of the March lows.  We are looking for a more substantial rally but not until later in the year.  For 121 trading sessions, nearly six months, the Dow has averaged daily moves of 132.6 points!  We expect volatility to subside soon and for a bit of boredom to return.     
 

We are compelled to once again refer to short selling as a broken and corrupted mechanic of the U.S. stock market.  Simply put, the phenomenal growth of derivatives (put and call options) has required equal growth in the ability of market makers to hedge.  Thus, we have created a situation in which a vast amount of stock must be shorted, whether it can be legitimately borrowed or not.  As a consequence, and aided by the ability to short on downticks, we are in the midst of a short sellers paradise, a highly diluted arena where there are far more shares or “share entitlements” held by customers than shares authorized by corporate Treasuries.  Short interest has increased by 56% in only one year on the New York Stock Exchange.  Recently, the total short interest reported by the NYSE and Nasdaq was roughly 25 billion shares.  How many of these have NOT been legitimately borrowed and were naked shorted by market makers to hedge option positions remains an unknown.  As of mid-March, 5.4% of the entire float of the S&P 500 were sold short.  We have no opinion whatsoever on the outlook for Nutrisystems (NTRI), but we are completely convinced that there is no way for an investor to gain a fair shake holding a position in a company where 61% of the float is short.  Bear in mind, every share that is shorted must be sold to a buyer, so in the case of NTRI, there are now 19.2 million shares or “share entitlements” in customer accounts, in addition to the 33.6 million shares authorized and outstanding.  Whatever the outlook for NTRI might be, this tremendous dilution has ensured a lower price per share.  The system is broken.  Caveat emptor.           

The collapse of stocks finally had a negative effect on both the asset base of exchange traded funds and the total number of funds.  Assets fell 8% from the end of December through the end of February and only five new ETFs were trading.  Could this be the end of an era?  Not likely.  Not yet anyway.  As the mania conclusively proved into March of 2000, there is no way to reasonably estimate how far a trend may extend.  As John Maynard Keynes once said, the market can remain irrational longer than you can remain solvent.  Thus, we are not yet betting against further growth in ETFs. 

Our skepticism was rewarded a couple of weeks ago.  No doubt you are familiar with the comic scene of someone spewing out the contents of his drink after being startled by some inane comment.  Well, your Editor's turn came on April 3rd, as Invesco Powershares Capital Management listed the details for its new Exchange Traded Fund, the PowerShares NASDAQ NextQ Portfolio (Nasdaq:PNXQ).  According to the press release, "The PowerShares NASDAQ NextQ Portfolio seeks investment results that correspond generally to the price and yield….of an equity index called the NASDAQ Q-50 Index...a market-capitalization weighted index designed to track the performance of the 50 securities that are next in line to replace the securities currently included in the NASDAQ-100…."  Hence, the moniker of NEXT Q, as in the illustrious Qs, one of the most heavily traded equity derivatives of all time.  The Qs are arguably the second most successful stock entity of all time, behind the SPY Spyders.  Of the 425 million shares outstanding, 43% are traded every single day.  Thus, the entire capitalization of this issue turns over every 2.3 days and close to 110 times each year.  Despite the insistence of Nasdaq that the Qs are an "investment" in the future, on average, shares purchased on a Monday opening are usually sold by 11:32 Wednesday morning.  For those who may doubt the casino aspect of the modern stock market, the Qs act as incontrovertible evidence that we have completely corrupted the theme of investment.  All that matters in the financial markets is product, product, product.  And as the ABX indexes have proved beyond a shadow of a doubt, some products are so easy to manipulate that the derivative product has now taken precedence over the derived securities themselves.  The tail wags the dog.  

The growth rate of ETFs is more than 50% annualized over the last eight years.  Just how amazing is this phenomenon?  The math is simple enough; if the rate of growth remains unchecked, there will be more ETFs trading than stocks in only five years!  While this eventuality may sound supremely silly, remember, it’s all about product.  The same financial industry that gave us SWAPs and CDOs is clearly capable of creating any number of securities in the quest to sell “product.”  And while entirely ridiculous, it is becoming way too easy to speculate another NEXT step, the creation of an ETF for Nasdaq issues ranked 151-200, and yet another, numbers 201-250 and so on.  Where does it all end?  It ends with a prolonged bear market and the dissolution of all unnecessary products like the NEXT.   
 

ABOUT ALAN M. NEWMAN

Alan M. Newman has been the Editor of CROSSCURRENTS since the first issue was published in May of 1990. Mr. Newman is also a member of the Market Technician's Association and has been widely quoted for years by the financial press, media, and other newsletters and has written articles for BARRON'S.

The newsletter is published roughly every three weeks and focuses on economic and stock market commentary, often covering controversial subjects. Several proprietary technical indicators are usually featured in every issue accompanied by current interpretation.  Broad samples of our work can be viewed at http://www.cross-currents.net/. 

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