Irrational Exuberance Won’t Last

06/27/2007 12:00 am EST

Focus:

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, finds more weakness in the market than investors recognize, but he thinks they will eventually notice and abandon poor performers.

The irrationality in the market is killing me!

I know irrationality is a core component of the markets, but these past few weeks have seen more than their fair share of illogical activity.

We could use a good market smackdown to flush out the stupid and irrational investors who keep moving big amounts of cash into otherwise-ailing companies. It's amazing how a little bit of exuberance in the overall markets can drag along stock valuations that would otherwise be struggling to see the light of day.

The market is getting stronger-the brief downturn in the bond market and the rise in interest rates near 5.25% is over, for the general markets, although the ramifications for housing, banking and other financial services has not yet been fully priced into stocks.

There is no hope of a Fed interest-rate cut this year, but there is also little fear of a rate rise due to the bond-market-inspired correction and manageable inflation.

That being said, I am beginning to see weakness in the trading in some sectors, including homebuilding, technology and a few other names and segments where private equity and buyout mania were the strongest before the recent correction.

The weakness in tech is being driven in part by slowdowns in cell phone growth (including fear of what a successful iPhone release can do to its competitors) and the realization that business capital spending is not going to pick up this summer and may remain weak throughout the year.

The new weakness in segments that were previously on fire due to private equity activity is understandable, as merger deals lessen with interest rate increases.

One last data point-bearish sentiment, based on surveys of investors, is the lowest since mid-2004-and that itself is a very bearish sign, as the market almost always moves against extremes in sentiment.

Bottom line: I am still optimistic that fundamental weakness will be punished, and not the slightest bit deterred from adding short-side positions to our portfolios.

My feeling is that the homebuilding industry and its cousin, mortgage lending, are in trouble that is deepening by the hour as lending standards tighten. It will simply be harder to qualify individuals to become borrowers. This, in turn, will lead to fewer people paying the interest rates on their loans that these banks are counting on.

The subprime-lending debacle has trickled up to impact not just the borrowers and their lenders, but also the big guns themselves who lend to creditors. It also says that the problems aren't going away any time soon because the cleanup is too massive and high-profile to quietly fade into oblivion.

As investors get a bit more fearful, they will desert companies with fundamental problems. Have no fear, as bad fundamentals will win out. Rational investors will prevail, and the markets will eventually bow to the rational investor's good judgment.

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