Last Week in Review, Market Shorts at Bearish Levels

Another icky week and more worries. Once again stocks declined last week in the face of credit concerns, recession worries, high oil prices and inflation fears. The S&P 500 fell 1.8% during the week to 1239. we are firmly in Bear territory now.

As we have discussed before the Fed is between a rock and a hard place. It cannot serve dual mistresses of low inflation and economic growth. So in order to keep the peace it will have to keep the Fed funds rate at 2%. It will continue to aggressively use what ever tools it has at its disposal to create liquidity and fight off market instability. We will continue to see the Fed step in as necessary as it did this weekend to provide liquidity to Fannie Mae and Freddie Mac.

The next chart highlights the amount of short interest in the market today. This measure depicts the percentage of trading volume that is betting the market will go down. Historically, levels this bearish have been fore bearers of future market rallies.

So what is the outlook from here? Presently, the U.S. equity market is in the process of making its third bottom (the first occurring in mid-January and the second in mid-March). The next notable move will probably be up as fears begins to abate.

As long as oil prices keep rising, stocks will remain under pressure, central banks will be unable to act and the risk of recession will grow. In the long term, for the markets to recover will require oil prices to abate which means the demand for oil must subside. Demand pressures should subside as the global economy continues to slow. It will become ever more difficult for oil prices to continue their unprecedented drive higher as demand pressures abate. The bottom line is that a correction in oil prices is a necessary if the world economy is to avoid a major slump, for inflation to decline and for equity markets to enjoy a sustained rally. At this point oil prices haven't shown any weakness so it is unclear when things will begin to get better.