R&R

I’ve been bullish the market since the mid-January capitulation lows. Back then I highlighted the depths of market sentiment and the explosion of volatility – both of which have a good track-record of reaching extremes just as the market troughs. Albeit, they can’t distinguish between lows that are temporary – say three months – and lows that are durable. I took the chance to load up again in mid-March. And I took the view that commodities, and resources/infrastructure stocks with good cost control, would lead the way.

On a more fundamental basis I’ve also highlighted the reacceleration of global reserves, the end of destocking in basic goods, and the US tax break. All were reasons to expect a decent cyclical recovery through the third quarter. Finally a piece from Morgan Stanley caught my eye – the market was pricing less growth into stocks than at any time in the last 14 years. I thought that meant that resources stocks, at the very least, could get re-rated.

So now we’ve seen 1000 points on the Dow, and some resources stocks, like Eramet, have doubled, it’s worth looking back at the indicators.

And, in short, the risk/reward has deteriorated. And as I’m a risk/reward rather than a pure momentum trader, I’m going to pull in my horns. I’m moving from around 110% net long equity back to 60% net long. And looking to shrink further if any downward move picks up steam.

So why the change? First off, the technicals. Investor sentiment has moved back to neutral. Insider buying is fading away. Volatility has fallen back to the lows of the upward channel established from July last year. And the RSI (relative strength) on the Eurostoxx has jumped to 60 – typically the high for a bear market rally – and likely decent resistance if we’re still in the bull.

Fundamentally, the global reserves issue remains unchanged – reserves have accelerated to grow at a 25% yoy lick – and that suggests I want to remain structurally positive on growth. On my trading rules, following Gartman, I don’t want to go net short equities at any point, even for a trade. And FDI into China has also reaccelerated – usually a good leading indicator of a growth boom to come. Structurally, then, commodities are going to remain the best asset – so I’m happy with the large positions I have in resources and infrastructure stocks, and in the commodities themselves.

But something fundamental has changed – and that’s my crowding out indicator. This indicator works on a simple idea – that moves in oil and bond yields trigger cycles in consumer spending and domestic profitability in the US. It’s the crowding in/crowding out principle. If oil and bond yields fall sharply, as they did in August of 2006, then that opens up space for more consumer spending and rising corporate profitability. That got me bullish stocks back then, which was a trade that worked, despite the Feb 2007 hiccup, all the way through to June the following year.

But lately, that indicator has started to flash amber. Now oil is in the hundred and teens – and particularly because it’s got there fast in recent weeks – there is good cause to think that US consumers are going to feel a sharp shock. If we combine that with the recent back-up in bond yields, as well as the well documented drought in credit availability, it suggests that the cyclical rebound story is going to suffer some headwinds. And finally, the main driver of stock ratings – inflation – remains elevated, that acts further against the chance of a sustained re-rating from here.

I thought the market was paying me to be long stocks in mid-January and mid-March, and it was paying me double to be long resources. That risk premium has now shrunken substantially. I’ve made 12.5% on the portfolio from the point I went active in mid-February, and it’s now time to hunker down and wait for some better opportunities. I’ve cut my risk by half on Friday and this morning, and I will likely cut my Walmart, and my financial shares shortly. Tomorrow I’ll talk about some short positions I am planning.