"It's no longer a question of staying healthy. It's a question of finding a sickness you like." -       Jackie Mason.   Finding the right answers, so the saying goes, is easy; it's asking the right questions that's difficult. Mired in the midst of perhaps the most difficult-to-interpret markets for a generation, here are some of ours.   1. Isn't the market's myopic focus on the oil price more than a little simplistic ?   I'll keep this short but not so sweet.  The light volume we are seeing on the market is a function of two things.  First is the topic all media is talking about - the end of summer and final vacations.  Yeah, yeah the week before Labor Day is traditionally light volume for that reason, but NOT this light! The market continues its upward trend despite the ongoing proliferation of horrible news. If the market is moving from bear-market rally into a full-fledged bull market, we should see a noticeable change in buying volume and price momentum accelerating to the upside.  Instead what we are witnessing is rising prices on ever weakening volume.  The market could continue up in this fashion, but I doubt it.

Hans Hufschmid, former partner at Long-Term Capital Management, is stressing how this time around it is much worse than it was in 1998 when LTCM went under (see Bloomberg article). The main reason? This time it affects everyone. Given that hedge funds benefit and even survive on credit and leverage, current liquidity issues are forcing many to take less exotic and esoteric positions, essentially reducing flexibility and opportunity. Of course, it is easy to forget that it was not exactly a picnic for everyone after the LTCM collapse, but intervention by the Fed did soften the impact. As mentioned in a previous post, July has been a bad month for hedge funds, with data from Hedge Fund Research showing that on average funds fell 2.4 percent in July and are down 3.5 percent year-to-date. Furthermore, daily net asset value estimates are down 2.8 percent in the month. As a result, fewer funds are starting up, and some smaller funds are closing down, crowded out by larger players with better liquidity and capital, although emerging hedge funds may be outperforming (see previous posts here and here).

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As reported at the Financial Times, US banks are being asked by the Federal Reserve to run a comprehensive series of stress tests to ensure they have enough liquidity to withstand various types of financial shock. The Fed regulators are asking for scenario analysis and testing to get an idea of how the banks would perform if there was a sudden and sharp downturn in the markets, or if an individual bank had to endure a major liquidity shortage, such as the one that brought down Bear Stearns. The tests are simulating mild to catastrophic disruptions, and appear to be focusing on the balances held for the various prime brokerage businesses that lend money to hedge funds. A few hedge funds have blown-up as a result of the recent credit meltdown. It is unclear if these failures were simply a warning sign of something bigger that is worrying the Fed, or just one of many areas in need of scrutiny.

While it is unknown if and how the Fed will use the specific data, the results could provide the information they need to implement new regulatory requirements if as proposed by policymakers they eventually take over some of the responsibility currently given to the SEC and other regulators. New requirements for regulatory capital are always met with mixed emotions. On the one hand, diligent and conservative risk management can provide confidence to both the markets and investors that a company can remain solvent, even in tough times. On the other hand, stricter regulation is usually followed by higher levels of regulatory capital that must be set aside, thereby reducing the banks ability to deploy its capital in the most profitable manner. The Fed and SEC recently identified the monitoring of liquidity as something they want to cooperate on with the investment banks. This current move appears to be one of the initial steps.

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Just when it seemed like the financial stocks were gaining some solid footing as all the subprime shoes drop, American Int'l Group (NYSE: AIG) dropped another one with its third consecutive, multi-billion dollar quarterly loss. AIG closed down 18% and I take a closer look at their troubles in my story, “Pulling in the Reins on Risk,” where I explain something that came out in the AIG conference call which may have more than a few investors worried. The Dow has been down six of the last seven weeks.  It's a pretty weak market.  However, since the low set July 15th we've seen a rotation as money flowed out from the oil and material sectors and into the financials.  Last week was like a tug of war with the Dow down 200 Monday; up 200 Tuesday and Wednesday; followed by down 200 Thursday and finished the week almost where it started.  If the financials really can get its legs underneath we could be in for a better market going forward.  I would like to see broader participation from other sectors before buying in.

There is an interesting article at the International Herald Tribune about how forecasting on Wall Street is getting "too wild," and how forecasts are getting less accurate. Data from Thomson Reuters finds that analysts correctly predict earnings only a fifth of the time. Approximately two-thirds of quarterly earnings beating estimates, with the remaining estimates being too low. This is not surprising since many companies attempt to managing earnings by reducing expectations and then delivering better-than-expected results. This year, only about 10% of companies matched expectations. Again, probably a combination of poor forecasting and earnings management by companies.

As mentioned in the article,

"Even the collective wisdom of the marketplace has been wrong time and again. The stock market, that weathervane for corporate profits and the economy, keeps swinging from fear to greed and back. A glance at the major stock indexes over the past year reveals a host of false bottoms and fools' rallies."

In fact, just looking at a Citigroup (NYSE: C), General Motors (NYSE: GM), Ford (NYSE: F), JPMorgan (NYSE: JPM) and other similar companies gives a picture of stocks that are relatively flat over the last month or so, even though price action during this time has made some significant moves up and down.

Of interest is that just as the markets become almost too difficult to forecast, due to market conditions and headwinds that reduce clarity going forward and prevent past trends from being trusted, is the exact time investors are looking for guidance, hanging on every forecast - and, in some instances, trading on that guidance as well. The recent moves also have the feel of the late 1990s in which new yearly price forecasts were meet in a day to two as retail investors piled in and bid up prices in an attempt to board the train before it left the station. Things have not gotten that extreme yet in the opposite direction, and the circumstances are certainly different, but the faith and need for guidance from Wall Street, or anyone for that matter, is reaching interesting levels. Whether this signals a reversal, as it did in early 2000 (but in the opposite direction), is difficult to tell. Furthermore, even if it does, it may take a while to see the effects. After all, Greenspan gave his "irrational exuberance" speech in December 1996, over three years before the market finally corrected and came to its senses.

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When you hear this clever slogan on CNBC's Fast Money, just remember it applies to a ever more narrow chorus of traders-those who try to trade for a living. Over the past year the window to let the trades play out has shrank from three to four weeks to three to four days and, in some cases three to four hours. During the 2003-2008 bull market you could safely put these trades on and successfully make lots of money, allowing them to play out over the course of three to four months.

If I could pick only one ticker to watch in order to gauge the market's health in the current environment, it would probably be (AMEX: XLF), the most popular of the financial sector ETFs. You could make an argument for (AMEX: RKH) the regional bank ETF, (NSDQ: XBD), the broker dealer ETF, or any number of others, but XLF covers the entire financial sector, from Allstate (NYSE: ALL) to Zions Bancorp (NDSQ: ZION).

 With all the talk about the degree of a VIX spike needed to signal a bottom and other measures of capitulation, I am surprised I have not heard anyone else mention the volume in XLF yesterday. As shown in the graphic below, XLF traded over 469 million shares yesterday, eclipsing the previous volume record (set just last Friday), by over 150 million shares. The 469 million share turnover also represents 3.3 standard deviations above the mean, which translates into an extremely unlikely event. [Note that in the chart below, the Bollinger band settings for volume are for 3 standard deviations instead of the default 2 setting] This is capitulation-level volume in the sector that is most important to the stock market at the moment. If XLF can weather all the financial sector earnings due out tomorrow, I suspect that a bottom will be in for the financial sector.