Wednesday, July 30, 2008

Market Update

Yesterday's rally appears to have been fueled by an extension of the "no short sale" rule another 30 days. The implementation of the initial rule two weeks ago led to a sharp rally in many financials and I'd expect this extension to add at least 5-10% to many of these names.

However, the bigger game in town right now is collapse of oil prices. Let's see if I can walk you through what has happened in the past few weeks. The demand destruction caused by $4+ gas has actually changed some driving habits in the US slightly. That has had a small effect on the price of oil. The biggest contributor to this recent sell-off however, appears to be the strengthening dollar. So why is the dollar gaining strength in the face of a very weak US economy?

Well, investors are always trying to see ten moves ahead and this is how the equation works - Inflation is getting out of hand, so the Federal Reserve is likely to start raising rates (probably after the election), so the US dollar will strengthen when rates go up, so oil will fall when the US $ goes up. Hedge funds (that have been the fast money behind the latest move from $80 to $140) are looking to lock in their gains in oil - if you got to keep 20% of the profits that you delivered to investors you would want to lock in gains as well. Thus, the trade right now is unload oil and buy equities for the next little bump up. I've said for sometime that $70-$80/barrel is the right price for oil given demand, OPEC issued a similar statement yesterday.

I'd expect this to play out through mid-August (all of Wall Street goes to Nantucket on 8/15). By mid-September look for everyone to get nervous about earnings again (and the no-short rule will have expired by then) and you can be comfortable being short again at that time.

Cheers.

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