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Created:
28 April 2008
Written by:
Simon Thompson

It's now crunch time for this equity bear market rally, as the strong upward move seen over the past six weeks is about to come up against a growing number of significant obstacles. For starters, we are entering what is historically the most difficult period of the year to make money from holding shares - since 1990, the FTSE All-Share index has produced an average return of just 0.25 per cent in the six-month period from the start of May to the end of October. By comparison, in the past 17 years, the UK market has posted an average gain of 7.1 per cent between the start of November and the end of April. So having rallied a healthy 13 per cent since mid-March, this seasonal investing trend is reason enough to be cautious.

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But there's more. The stock market is advancing on deteriorating breadth, just as it did last October when it peaked out. In fact, the breadth indicators have turned down at more or less the same level as six months ago (daily index breadth indicators are available here). And this is not the only technical headwind the market is facing, as the falling bear market trendline that has capped previous rallies will shortly come into play (see chart below).

Other ingredients for a stock market storm are now in place, too. For one, the record oil price - Nymex West Texas Intermediate touched $120 a barrel last week, up 40 per cent in the past three months - is a double-edged sword, with the pain felt by consumers and companies far outweighing the benefits of the earnings prop to the oil majors. Moreover, I don't buy the argument that we are more immune to the high oil price than we were three decades ago, during the 1970s oil price shock, simply because industrialised nations use less of the commodity per energy unit of economic output. In fact, in the US, a country teetering on the brink of recession, the proportion of crude oil imports to output has risen significantly in the past decade. That not only makes the recent prices more inflationary, but means that further hikes are less easily absorbed, too. At some point, and we could be close, risk-aversion will rise as investors become nervous about the escalating oil price.

Interestingly, the oil price has historically formed a seasonal high in April that has then been followed by a consolidation period lasting several weeks before forming a low in May. However, even if there is some near-term respite, I don't think this is going to help the equity markets. Indeed, if the speculative funds that pushed the oil price up decide to bank profits, the oil majors are more likely to give up some of the strong gains registered in recent weeks, pulling the market down.

I also think that investors have yet to fully factor in the deteriorating outlook for profits from the financial sector. As I pointed out last week, the debt markets are giving a strong signal that corporate defaults are about to rise sharply. Unfortunately, consumer loan books look set to be heading in the same direction as the housing bubble deflates. Higher corporate and personal defaults coupled with tightening lending and loan rationing can mean lower profits, further balance sheet stress and potential dividend cuts in the banking sector.

In the circumstances, I believe the time is right to average into shorts on the blue chip index. So to allow enough time for the final leg of the bear market to unfold, my favoured play is to use covered put warrants.

In particular, Société Générale put warrants SM29, which expire on 19 December 2008, look ideal to play the downside (uk.warrants.com). The warrants have an exercise price of 6600, parity of 1000:1 and offer 4.9 times gearing to the underlying index. With the FTSE 100 trading at 6130, the warrants are priced at 72p, or 720 points per contract. In other words, each contract has 470 points (47p per warrant) of intrinsic value and 250 points (25p per warrant) of time value, which looks decent value to me, considering they have eight months to expiry.

My index price target remains 5000 to complete the 25 per cent minimum peak-to-trough decline consistent with previous bear markets that followed long-running bull markets where prices had previously doubled (Histrionics, 11 April 2008). The target is also in keeping with a modest earnings recession, whereby the drip-feed effect of earnings downgrades pulls the market down. If, like me, you believe this bear market scenario will play out before the end of the year, then the SM29 warrants offer 120 per cent potential upside.

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