The case against the markets

Bearish indicators continue to pile up, leaving many professional money managers to predict that things will get worse before they get better.

Mohamed El-Erian, chief executive of Pacific Investment Management Co. LLC, who not long ago warned that the world was on the eve of another financial crisis, said it will be another year before the U.S. economy shows growth, thanks in part to Washington’s “dysfunctionality” and troubling “international head winds.”

“We think it will be hard for the U.S. growth rate to be much above zero in the next 12 months,” Mr. El-Erian said. “As a result, unemployment will remain stubbornly high and the problem will become more structural in nature and, therefore, harder to solve over time.”

He looks at a set of indicators on global dynamics, balance sheet sustainability and policy responsiveness because these speak to the forces driving today’s markets — “drivers that, for now, dominate bottom-up indicators,” Mr. El-Erian said.

Other investment managers are using data based on the number of short positions on the exchanges, technical market predictors, number of people filing for unemployment benefits for the first time, lending rates between European banks — even what companies are buying — to gauge the economic winds, and they conclude that equity investors face a gloomy ride.

Kevin Byrnes, senior analyst for TFS Capital LLC, has watched the number of short-interest positions rise on the major markets as volatility has increased investor risk without much of a reward.

For the two-month period through Sept. 15, short interest on the New York Stock Exchange increased by 17.1% to nearly 15.7 billion shares, the highest level in the past two years.

“During this period, investors in the Dow [Jones Industrial Average] or Nasdaq [Composite Index] saw little difference in the final value of their positions but had to assume significant volatility in the interim, all of which was downside, relative to the starting value,” Mr. Byrnes said. “This should only serve to increase the conviction of short-sellers that the market has further to fall.”

EUROPE TEETERING

Europe’s credit crisis has Bob Haberkorn, senior market strategist at MF Global, feeling especially bearish. He also uses the Fibonacci analysis, based on the theory that prices tend to drop or climb by certain percentages after reaching a high or low. Currently, it would call for a 40-point dip in the S&P 500, he said.

“Every day, it’s a new story out of Europe,” Mr. Haberkorn said. “I think the situation in Europe will have more negative news for the stock market, and it’s not too rosy.”

The S&P 500 is trading about 1% below the level it was a year ago, closing Friday at 1,131, compared to 1,141 a year ago. Since then, it has gone up as high as 1,370 and down as low as 1,101.

“A lot of investors feel like the market is all over the place right now,” said Jeffrey Kleintop, chief market strategist at LPL Financial. “We see the S&P 500 staying in an 1,120 to 1,220 range, possibly ending the year with a modest single-digit gain.”

Mr. Kleintop pointed to initial jobless claims, which were are at 417,000 for the most recent four-week moving average, suggesting that the labor market is sluggish and not improving much, though he pointed out that it doesn’t seem to be deteriorating further, either.

“You need a strong labor market to sustain a recovery,” Mr. Kleintop said. He said that he would feel less bearish if the monthly average initial jobless claims were to drop below 400,000 by the end of 2011.

The weekly data actually showed claims down to 391,000 for the most recent week reported, the week ended Sept. 24

Brian Levitt, corporate economist for OppenheimerFunds Inc., said that he is cautious in the near term because of the tremendous volatility in the markets, citing Europe as an important factor. He looks at the interbank lending rates in Europe, which are at about 80 basis points, well above the normal level.

The average for the past 15 months has been about 30 basis points, Mr. Levitt said.

INCREASED UNCERTAINTY

“There’s increased uncertainty in the banking system there and concern about lending,” he said. “Not until there is full clarity can we move beyond what’s happening in Europe.”

A telling U.S. indicator is the Institute for Supply Management’s purchasing managers indexes, Mr. Levitt said.

They are at 50%, suggesting half of companies are contracting and half are expanding. That level was more positive a few months ago, at 60%, and that drop concerns him.

“The fundamentals of corporate America are quite good; businesses should be investing,” Mr. Levitt said.

Diane Pearson, an adviser with Legend Financial Advisors Inc., said the indicators that she heeds show continued volatility and a falling equities market.

For one, the Chicago Board Options Exchange Volatility Index, the benchmark gauge of U.S. stock option prices, has been on the rise since July, closing Friday at 42.96%. The indicator was 23.25% a year ago.

MORE VOLATILITY

“There’s going to be continued volatility like we’ve had in the past three months, with extreme movements, and it’s not going to be unheard of to have 4% and 5% days in either direction,” Ms. Pearson said. “Investors are going to have to get used to that on an ongoing basis.”

In late August, the S&P 500 moved to a “death cross” situation where the 50-day moving average is going down and the 200-day moving average is going up, Ms. Pearson said.

“That suggests it will be a challenging time for equities; it’s not a buy signal to us, and we’ll sit on the sidelines,” Ms. Pearson said. “This is one strategy we’ve been following a whole lot closer to see what is anticipated in various markets.”

[email protected]