Skip to main content

Preparing for a Down Market

The Dow could drop below 10,000 if stocks haven't factored in an economy in decline.

The market is slowly beginning to react to the deceleration of economic data.

The only market fundamental that could successfully confront the worsening data would be valuation. If declining economic conditions were already priced into stocks than we would see a flat market until the data started to improve. This is the best case scenario.

However, if the declining economy isn't priced into stocks then it will provide the fuel to take the market back to the low end of its trading range below Dow 10,000. This is the most likely scenario.

The most important economic data is coming from the real estate sector. Without new construction, this recovery isn't going any higher. A comprehensive understanding of the direction of economic data is the most important analysis any investor can have.

It's what gives us conviction in our portfolio allocations. It saves us from being fully invested during high risk times. Remember, the most important thing any investor can do is be out of the market during the big drops. This strategy of risk management is even more important than being in the market for the big up days.

Our interpretation of the current economic climate is that we are in the midst of a temporary pause/contraction that will establish a new baseline from which the economy can resume its recovery.

The leading causes of this temporary pause/contraction are unintended consequences of government intervention that have spooked companies from hiring and prolonged the foreclosure cycle.

Because of unemployment and foreclosure pressure, home price depreciation has another leg down in store for the market. We are still 12 months away from meaningful construction jobs creation. Until we see a meaningful improvement in new home permits, median home prices, existing home inventories, etc.,we will be stuck in a trading range.

Today's employment report reinforces our interpretation of the economic climate. Temporary jobs dropped for the first time in months. Normally temp jobs are a leading indicator of employment gains but in this case, it hasn't materialized.

We know it has nothing to do with corporate balance sheets as they are flush with cash like never before. The only explanation is that companies don't want to commit to the entitlement uncertainties cause by health care reform.

Scroll to Continue

TheStreet Recommends

The reservoir of resources available in today's world of globalization makes it so companies don't feel the need to hire if conditions are not in their favor.

Adding to this uncertainty are the potential tax increases in 2011. In our July E Weather Newsletter we outlined a definition of the "new normal" that casts global governments as the economic villain's in contrast to the private sector as the economic hero's.

Sure enough in this employment report we see 38,000 jobs lost in local government because of the troubling fiscal situation. Budget gaps will continue to cause job and spending cuts.

The private sector looks relatively strong with 36,000 new jobs in manufacturing, 12,200 new jobs in transportation, 6,000 in leisure, 6,700 in retail, 8,400 in wholesale but sure enough we lost 11,000 construction jobs and we lost 17,000 financial services jobs that were mostly tied to the real estate industry. The economic view is crystal clear.

As economic leaders present solutions to the problems we are facing, the market should be able to rally. A tax incentive for buying foreclosed properties would be a wonderful aid. Quantitative easing from the Fed would help to prevent a spike down in asset backed securities. Investors will be looking for a plan to be presented at the August 10



If we don't get such a plan, it will be time to add more short positions to the portfolio for a probable drop back to the 9,500 level on the Dow. Our current allocations of ETF's, Apple LEAPS, and QQQQ puts are designed for a flat market.

If the Fed fails to buoy confidence, we will shift towards allocations designed for a down market. Today's employment report did nothing to help the bullish cause.

At the time of publication, Schwarz had positions in Apple, Powershares QQQ Trust.

Jason Schwarz is an option strategist for Lone Peak Asset Management in Westlake Village, Calif. He is also the founder of the popular investment newsletter available at Over the past few years, Schwarz has gained acclaim for his market calls on the price of oil, Bank of America, Apple, E*Trade, and his precision investing in S&P 500 option LEAPS. His book, The Alpha Hunter, is set to be released by McGraw Hill in December 2009.