An Ugly Correction is Coming

To date, the stock market is up 48% since its March lows. This is truly incredible when you consider the underlying economic picture: normally when the market rallies 40%+ from a bear market low, the economy is already nine months into recovery mode. Indeed, assuming the market is trading based on earnings, the S&P 500 is currently discounting earnings growth of 40-50% for 2010. The odds of that happening are about one in one million.

A closer examination of this rally reveals the degree to which “junk” has triumphed over value. Since July 10th:

  • The 50 smallest stocks have outperformed the largest 50 stocks by 7.5%.
  • The 50 most shorted stocks have beaten the 50 least shorted stocks by 8.8%.

Why is this?

Because this rally has largely been a short squeeze.

Consider that the short interest has plunged 72% in the last two months. Those industries that should be falling the most right now due to the world’s economic contraction (energy, materials, etc.) have seen the largest drop in short interest: Energy -90%, Materials -94%, Financials -86%.

In simple terms, this rally was the MOTHER of all short squeezes. The fact that it occurred on next to no volume and crummy fundamentals sets the stage for a VERY ugly correction.

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