Capital Observer Will Return Monday

As of 3:00 PM we are seeing more call buying today than we have seen the entire way up and the market is flattish. That is not what the bulls want to see. I wanted to remind readers that I believe the ISM has a good chance of disappointing on Friday.

I will be out for the next two days and return on Monday. I will be back to a regular schedule next week. Have a great weekend.

Citigroup Rumors

Doug Kass of RealMoneySilver.com is reporting rumors that the government is considering selling the balance of its Citigroup shares all at once. That would amount to roughly a $12 billion offering. I believe that an offering that big would be a negative for the overall market. It would have to happen by tomorrow for the government to avoid the blackout period, so if we don't hear something very soon its likely just a rumor.

No Appetite

The largest IPO of the week, Liberty Mutual, has been delayed. Even though the market has soared there is little appetite for more financials. I'm not sure if that is good or bad for the financials.

Sick Of Hearing About Gold

Everywhere I look I am seeing articles about gold and hearing lofty price targets. This is typically seen very late in a trend. I would not be surprised to see a short term top. I don't invest in commodities and am wagering exactly $0 on this.

Downgraded

Amgen is weak on a downgrade. I have used the weakness to sell out of the money naked puts.

Where Are They Now

I was pounding the table on healthcare stocks this Summer and the sector has soared. While I am a little less enthusiastic on the sector, I believe there is still value there.

Pharmaceuticals have done well as investors have found a new love for high dividend paying stocks. I believe that large cap biotech offers better value. Companies like Gilead and Amgen (I own both) trade at lower multiples than many pharma companies and offer better opportunities for growth. I believe the discount exists solely because of the dividends. Amgen and Gilead have been returning cash to shareholders via buybacks, which I believe is better than dividends at current valuations. I view large cap biotech as cheap, with pharma at the low end of fair value.

The multiples on the HMOs are still extremely low, although it is difficult for me to judge the political risks so I have taken a pass on this sector other than having had owned it through healthcare ETFs.

Medical devices is an area I am strongly considering investing in. The multiples are low and they don't face the same patent cliff issues that bio-pharma companies face. Additionally, their margins are smaller than bio-pharma companies so there is less room for governments to try and cut into their margins. There is some short term risk as estimates are still coming down. Even though I believe the stocks are more than adequately pricing that in, momentum is more important to most than value.

Complacency

There is an air of complacency in the market as fear no longer exists, unless one considers the fear of missing a rally. Bad economic numbers, sovereign spreads blowing out, currency wars, commodities surging? No problem, QEII is on the way.

Complacency is a very dangerous emotion in the stock market but that does not mean that the market is necessarily headed lower. Complacency only becomes dangerous once major investors have high equity allocations. This rally started 22 trading days ago at which time pessimism was widespread and equity allocations were low. Is 22 trading days enough time for the crowd to re-risk? I suspect that they still might have some firepower left.

I much prefer to buy at times when fear is widespread like at many points during the Summer. I have little interest in new purchases right now. But knowing that this rally started off of a base where the major players were de-risked, I am going to continue to err on the side of caution and give the rally room before trying to fight it. By late next week the rally will be thirty trading days old and the turn of the month will have passed. Better to wait and fight a tired, complacent bull.

The Hedge Fund Kid

It seems the market is not going to stop going up until every hedge fund out there capitulates and buys. Risk off, Risk on, Daniel san. Have a good night.

Taking The Under

Calculated Risk makes an excellent case for a big miss on the ISM number that will be released this Friday. The graph below created by Calculated Risk shows a large divergence between the regional manufacturing surveys in green and blue and the ISM in red. Based on the regional surveys we could see a 50 reading, meanwhile the expectations are for a 54.8 reading.

I am strongly considering taking the under right before the number is released. Unfortunately, the number comes out on the seasonally strong first of the month which might mute a negative reaction.

Wrote Naked SPY Calls

I wrote the October 117 SPY Calls naked. While I see the potential for one more rally, I believe it would be a good short entry point.

More Supply This Week

There is a $4 billion calendar of IPO's and secondaries this week. In addition, there have been some announcements of new secondaries like ED, AGNC and AEC. This supply is partially being offset by some cash M&A announced yesterday.

Removed Some Hedges

I used this whoosh lower to remove a small amount of hedges. I am slightly long. This is more a reflection of the fact that I am comfortable with the stocks I own, than the overall market.

As an aside, I intended to remove these hedges last week. I left a limit order in when I was out last week that missed being filled by pennies on Thursday. Had I been in, I would not have fought over those pennies.

Pass It On

From Marketwatch:
Peet's Coffee & Tea said late Monday it is raising the price on most drinks by 10 cents and bean prices by an average of 8% starting Wednesday. The increase is in response to about 35% rise in green Arabica coffee prices since early this year. Starbucks announced a similar move last week.

The Worst Possible Outcome

I believe the worst possible outcome for the equity market is stagflation and there is increasing evidence that is where we are heading. The best thing the bulls have going for them is that yields are so low everywhere else that in comparison the equity markets look much better. But how would those 2.5% dividend yields look in a world with inflation and little growth?

The CRB RIND index hit a new all time high yesterday, all the while we are seeing competitive currency devaluation. QEII would only exacerbate the situation. I would point out that the first time the Federal Reserve engaged in quantitative easing the dollar was strong. That is not currently the case and the results could differ this time around. To those that point to the wisdom of the bond markets I ask what was the bond market saying in 1982? Could it have been more wrong?

Surprise

When checking the statistics I was quite surprised to see that he market has managed to work off its overbought reading in the past two weeks, even though the S&P 500 has climbed nearly 2%. Breadth has been underperforming as the rally has narrowed. I would point out that we are not oversold yet.

 If we do get a nice down day some time this week it could probably be bought for a trade as that would get the market oversold and we would be heading into the seasonally strong turn of the month. One more rally next week would get the market overbought in the intermediate term and likely finally lead to a sentiment extreme. At that point we could probably expect a larger correction.

Beta Chase

Funds that were under exposed to the recent move higher are now chasing beta at any price. This is not something that is typically seen at bottoms. Additionally, protectionism is starting to rear its ugly head, which could possibly be the theme of the next correction. The following quote in the FT from the Brazilian Finance minister caught my attention
“We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness,” Mr Mantega said. By publicly asserting the existence of a “currency war”, Mr Mantega has admitted what many policymakers have been saying in private: a rising number of countries see a weaker exchange rate as a way to lift their economies. 
 I will take a pass on the win/win situation. Have a good night.

More On David Tepper

I hope it does not seem like I am picking on David Tepper because he is undoubtedly talented and more successful than I could ever hope to be. However, I have seen the investing public turn others into gods only to see them stumble shortly after.

Nobody knows for certain what will happen. Nobody. And the market is never a no lose situation. If everybody is focusing on how great David Tepper is than I want to show the other side of the trade and show that he is fallible. If everybody were picking on him, I would likely be defending him. 
  • David Tepper made a strong case for the financials in May at the Ira Sohn conference. They have been the worst performing group since.
  • Tepper made downbeat comments in August only to turn bullish after the Fed meeting last week at much higher prices.
  • Tepper has made most of his money in distressed situations, not by calling the near term direction of the stock market.

My Bull Case

I don't agree with David Tepper that we are in a win/win situation because of the Fed, but that does not mean the bulls don't have a case. The following is the bull case as I see it:

As long as the economy and earnings don't completely fall apart share buybacks by corporations, cash M&A and hedge fund re-risking could fuel a rally during the seasonally strong part of the year.

The bears have  a case as well as the economy is slowing. Combined with the imbalances, that makes the chances of an accident unusually high. Additionally, now that the market cleared its extreme oversold reading and the extremely negative sentiment there is room for downside even without an accident. 

Keep An Eye On CPI

If the Fed will indeed engage in QEII, than CPI is now the most important economic release. If CPI does not continue to show very low inflation than the Fed will have a tough time justifying their actions. I see numerous risks to CPI over the coming months:
  • Rents make up a disproportionate portion of the CPI and their are disparate stories across the country of landlords gaining the upper hand as more people choose to rent instead of buy.
  • The CRB keeps hitting new highs as many commodities are breaking out to multi year highs.
  • The dollar has been weakening and import prices have been rising.
  • The US is putting real pressure on the Chinese to weaken the yuan.
  • Airfares have been rising as the sector has seen consolidation. 
All these pressures are inflationary and if we do get a hot number than QEII might be in doubt. 

Edgeless

Since I have been away for a few days I want to look at where we are in this rally in terms of time. The current rally is 20 trading days old. It takes about 30 trading days or six weeks before there is a high probability of something more than a shallow pullback. If this rally lasts through next week it would set up a very high probability short opportunity, but currently we are neither overbought nor oversold on an intermediate term basis.

Looking at the shorter term we did the minimum last week by pulling back, so betting on a pullback is no longer the high probability trade it was early last week. At the same time a low risk long did not set up because we never became oversold. Normally, I would think the current setup was bullish but I can't help but suspect that the correction last week should have been a little longer but was cut short by the David Tepper rally. The poor statistics on Friday's rally, such as new 52 week highs contracting from earlier in the week, support that notion.

Sentiment too has not reached an extreme although it seems we are one rally away from turning the crowd to extreme optimism. All in all, the statistics are not giving a strong edge in either direction.

David Tepper's Sham Wow Moment

David Tepper's bull case could not have been presented in a better manner. The lead in included how rare it was to have him on TV, his stellar past performance and his amazing trade in the financials. Then he presented his case for the market in a brilliant manner, managing to make it seem exactly like his financial trade that helped him earn over 100%.

If I didn't know better I would have thought I was watching an infomercial with Billy Mays. I was sold on the market and I wondered if I bought one SPY, could I get a second free if I called now? Until I actually thought about the argument he made.

Stated simply David Tepper made the Bernanke/Greenspan Put argument. That same argument could have been made the entire way down in both of the meltdowns of the past decade. It also sounds very similar to the "liquidity" argument that was being made in April right before the market fell by 17%.

A year ago everybody was following John Paulson into the financials because he made "The Greatest Trade Ever". They have been the worst performing stocks since. I urge readers to judge David Tepper's bull case based on the merit of his argument and not based on his past performance or the convincing manner in which he presented.


Please note: I am not saying that the bull case is necessarily wrong, just that I don't agree with this particular argument.

The Tepper Effect

Four weeks ago sentiment was extremely negative. The market had been down for the better part of the past four months and that served to make the crowd very bearish. Hedge funds were no exception, as "de-risk" and "risk off" became the new catch phrases. Hedge fund surveys were showing very low equity allocations and second quarter investor letters written during the Summer were dour with few exceptions.

Four weeks and 11% later sentiment has improved and equity allocations are likely higher. However, four weeks is not enough time for allocations to move to a bullish extreme. Especially, considering that we are coming off of four months of de-risking and extreme negative sentiment. My best unscientific guess is that allocations are now neutral.

While generally sentiment swings from extreme to extreme, I doubted whether sentiment would move back to extreme bullishness as economic growth is still slowing and earnings should follow. Generally, when the market goes higher the primal urge to join the herd grows stronger and any excuse to join the herd will do. But the news flow has been so negative recently that it has not been conducive to extreme bullishness.

Then David Tepper steps on CNBC and gives the overgrown primates the intellectual cover they need to join the herd. A brilliant sounding argument that allows them to turn bullish regardless of the news flow. Heads I win, tails I win. Can't lose. If this argument catches on it has the potential to swing the crowd to extreme optimism and move hedge funds to bullish equity allocations. That would set up a very dangerous environment but it would mean higher prices in the interim.

For the purposes of this post, put aside what you think of the argument, as the perception of the crowd is reality (I think Tepper's argument is hogwash and will explain why in a later post). If this argument catches on it has the potential to fuel a continued rally.

David Tepper On CNBC

David Tepper's appearance on CNBC was credited for Friday's rally. While the market might have been up Friday without Tepper, I believe that at a minimum he contributed to the magnitude of the rise. I have a lot to say on the subject but first I want to make sure everybody has seen it, so here it is.

O Grande Offering

For those interested in the Petrobras offering, my understanding is the following. The secondary offering is greater than $70 billion but the majority is going to the Brazilian government, leaving roughly $30 billion for the public. Bids are due today and allocations will be known Thursday night.

I will be out tomorrow and Friday and will return Monday. I am leaving in a limit order to take off a portion of my hedges in case we do get a large swoon. Have a great weekend.

Thank you to all the readers who have been going to Amazon from my site, when making a purchase. Remember, if you shop at Amazon you could support the blog at no cost to yourself. There is an Amazon banner all the way at the bottom of the page or a number of links on the side. If you go to Amazon through any of those links when you make a purchase, the blog will receive a small percentage. The item will not cost you a penny more.

The First Dip

Dip buyers are getting their first chance to buy a pullback since the rally started, so its little surprise that 1130 on the S&P 500 has been defended on the first test. While I still believe that portfolio managers are under-invested and nervous, the greater than $40 billion worth of secondary offerings this week will go a long way in helping to get them invested. Due to how extended the markets are I expect that the upside will remain limited and a break of 1130 is still a very good possibility.

Market Brutality

I believe that Microsoft is being unfairly punished, as investors are disappointed that the dividend raise is not big enough. Microsoft is returning cash to shareholders whether it be through dividend raises or buybacks, the difference is immaterial to me . One can make a strong argument that a buyback is better as the stock is trading very cheaply. I am a little worried about the broader market so I will stay away for now but if I had to buy something it would be Microsoft.

Covered The SPY

I covered my SPY short as I will be out of the office tomorrow and Friday. I probably would not be able to resist reloading if we bounce before the end of the day.

Investors Intelligence Back In Neutral

The Investors Intelligence survey is squarely back in neutral territory with bulls slightly above 41% and bears slightly below 30%. Extreme bullishness tends to have bears around 20%. The market topped out in August with bulls in this area but it is typically not a great sell signal. I suspect that this did not fully take into account the breakout on Monday, so the number of bulls will likely be higher next week.

Keep Your Eye On The Ball

Every housing number that comes out leads to speculation about a housing recovery. If a number comes in .01% below expectations the bears claim housing will cease to exist and if there is a similar beat than the bulls declare its time to buy up all the condos in Florida.

The most ignored yet most important number is weekly mortgage applications for purchase. When one intends to buy a house the first thing they do is apply for a mortgage. Yet people would rather focus on numbers like Existing Home Sales, that measures the number of closings in the previous month. A closing happens many months after a mortgage application is filled out.

Mortgage applications for purchase have been steady at an extremely low level for many weeks now. There is no housing recovery. Don't hold your breath waiting for the next housing number.

The Deciding Factor

While sentiment is now on the bullish side, there is still room for sentiment to get more extreme whether looking at the put/call ratios, Rydex or the Investors Intelligence survey. The reason I decided to make a stand here on the short side is the shear amount of secondary offerings that are about to hit this market. I believe that the supply will at a minimum give the market pause through the end of the week and possibly takes the S&P 500 back down through 1130.

Now Short

I now have a starter short position and will add to it on further strength.

FOMC Volatility

I have put in orders following FOMC rate decisions that I thought had zero chances of getting filled and they did. I have orders in to short the SPY above the market.

Sold Gilead Calls

I sold the Gilead October 38 Calls against my long position.

High Expectations

I am hoping to get a chance to go short on the volatility surrounding the FOMC announcement. I am a little perplexed by some expectations for a quantitative easing announcement. Despite protests to the contrary Ben Bernanke takes his cues from the equity markets. Markets have been screaming higher leaving little reason to waste that bullet now. If investors are disappointed I might not get my chance.

Where Are They Now

I have not posted the put/call ratios in a while. Below is a look at the 10 Day moving average of the ISE Equity only. The 200 level has given the market problems since the March 2009 lows, save for April, when the ISE equity 10 Day MA made an all time high. I believe April was an outlier and that extreme of a level of bullishness is very rare. If the ISE Equity closes the day where it is now the 10 day moving average will be above 200.


I should note that the CBOE readings are not confirming this extreme of a reading. I always prefer when multiple indicators are saying the same thing. What is clear is that sentiment is no longer an asset for this market.

Mapping Out A Plan

The S&P 500 has rallied over 100 points without pulling back. The breakout above 1130 yesterday has finally swung sentiment firmly into the bullish camp, after investors had been fighting this rally tooth and nail the whole way up. Two massive secondary offerings from Petrobras and Deutsche Bank are about to hit the market and a flurry of smaller secondaries were announced after the bell yesterday. All these strongly argue for a pullback in the near term.

A decent case can be made for a continuation of this rally on an intermediate term basis, as hedge funds are still underweight stocks and corporations continue to repurchase shares. But in the short term the bear case seems more compelling to me.

The FOMC rate decision will be announced today. There is typically a lot of volatility surrounding these decisions. I will be looking to use that volatility for an entry point on the short side. Additionally, by that time most of the "breakout" buyers should be done.

Hold Fire

The bad news for the bulls is that they can no longer count on the shorts to buoy the market as I believe the short base is quite small after today. Additionally, today's move over 1130 is starting to make the bull camp seem crowded, making sentiment a headwind.

The good news for the bulls is that nearly every portfolio manager was caught completely flat footed by this 10% rally and they still have had little chance to get in. And that corporations continue to put cash to work via cash M&A and buybacks.

I believe the short side is looking increasingly interesting in the short term as the market will be digesting a lot of supply this week. Additionally, even if the market is headed higher it is likely that the breakout point, 1130 on the S&P 500, will be tested when this market finally decides to pull back.  Have a good night.

Cuidado

Energy is one of the stronger groups today. The huge Petrobras offering later in the week will likely have the largest effect on this group. I would be cautious in that group.

The Wrong Way To Invest

The following excellent quote is from Barry Ritholtz:
Then there is that other group.  They are all conclusion, zero input. Process is irrelevant to them, Outcome is all.

They work backwards. They start with a conclusion, and sift through all the data to justify that conclusion. They do not change their minds. They do not care about facts or data or input. They never admit mistakes. “Truth,” as we have discussed in the past, is an irrelevant inconvenience.
They are ideological jihadists.
This group contains a mix of bad fund managers, perma-xxxxs, political ideologues, corrupted journalists, partisan hacks. They are prisoners of the cognitive biases that are so fatal to good investors.
Its called “reaching a conclusion” for a reason;  its how you end, not how you begin. We do not say “reaching for a conclusion” but that is how member of this group seem to operates
Mr. Ritholtz is a little harsh because it is a cognitive bias (something which we are hardwired to do) to try and look for supporting facts to our opinions. Most people do not even realize that they do this. It took me many years to learn to overcome this bias.

Readers might notice that I am constantly making lists of both the bull and bear cases. That is because I am constantly weighing the evidence, even if it goes in the face of a position I hold. That is the opposite of guests on CNBC who are always so certain about where every market and commodity are going.  I know many view it as a weakness or indecision but it is quite the opposite. I doubt I would be able to trade for a living if I operated in any other way.

Juiced

We are already seeing a change in attitude. The ISE opened with put buying as everyone and their mother saw the resistance at 1130. Now that we have broken out and the market is 1% more expensive they have turned around and are buying calls. A close above 1130 should get them even more juiced. At that point I will likely start fading the crowd.

Breakout

It looks like we have broke out above 1130 and have set off some stop loss orders. I am going to give this some time and am in no rush to get short. Sentiment is not yet extreme but I suspect we are now on our way there.

Why Stocks Are Going Up: Part Two

Last week, I pointed out that share buybacks are a big reason the market has been rising. From Bloomberg:
Record-low interest rates are stoking the biggest increase in U.S. share buybacks ever.
American companies announced $55.9 billion in repurchases since June, data compiled by Birinyi Associates Inc. show. That adds to $93.5 billion in the second quarter and $108.3 billion during the first three months of the year, compared with $125 billion in all of 2009. Corporations are using debt to pay for buybacks after the average yield on U.S. investment grade bonds fell to an all-time low of 3.70 percent last month, data from London-based Barclays Plc show. 
...U.S. companies have announced $258 billion in buybacks so far this year, compared with $52 billion in the first three quarters of 2009, according to data compiled by Birinyi. The almost fivefold increase is the largest for any January-to- September period since at least 2000, when the Westport, Connecticut-based research firm started tracking the data. 
Unlike investors, when companies buy back shares they don't usually sell them. This is  a major reason that I am so hesitant to go short. As long as this type of buyback activity continues it is unlikely that the market will fall apart.

Up Than Down

When there is a widely watched support or resistance level like 1130 on the S&P 500, I prefer for it to get broken in order to get sentiment extreme. It is likely that many bears are using that level as a backstop and many fence sitters are waiting to see if the bulls can break above that level. A breakout above 1130 would likely cause a flurry of short covering and get the final holdouts into the bull camp.

I believe a breakout above 1130 early this week would setup a nice trade from the short side. Aside from the likelihood of finally getting sentiment extreme, there will be  a lot of supply mid-week. The greater than $30 billion Petrobras secondary is set to price mid-week and the Deutsche Bank $12 billion rights offering is also set to launch mid-week.

Both these secondaries are not US offerings so they will not have the same effect on our markets as if they were. But global markets are interconnected and these offerings are large enough to make a difference. At a minimum I believe they would give a rally pause, giving me a free look on the short side for a few days.

Unconvicted

The bears will argue that almost every top in the past year started out as a sideways range such as the one we have been in since Monday. Additionally, expiration often serves to help a trend persist only to see it reverse after expiration.The bulls will argue that the market is working off the overbought reading by going sideways as too many money managers are under invested.

Both have good arguments but gun to my head I would have to side with the bears. Even if the bulls manage to push this market above strong resistance at 1130, that move would likely be a last hoorah, as the market is very extended.

Thank you to the many readers that had kind words to say about the blog this week. Thank you for reading. Have a great weekend.

My Bad

Yesterday I wrote a column called Patience is A Virtue, where I wrote "Warren Buffet has said there are no called strikes in investing". Yet, on the same day I got sucked into a trade that I myself had said only had a marginal positive risk/reward profile. Luckily, the position was small and the loss I am taking is tiny. I have been trading very patiently for the past few months but once in a while a reminder is needed. Luckily, this one was cheap.

Writing SPY Puts

I am writing SPY 113 Puts expiring today on my small SPY short position. I want to exit the trade with a tiny loss. While I think the trade works, I would prefer for all the ducks to be lining up, including intermediate term sentiment.

Bail Us Out

European markets are lower on news that the Ireland is negotiating with Anglo Irish Bank bondholders, so that heaven forbid those who made bad investments actually take a partial loss. The largest risk for the market remains an economic event, which is a higher than normal possibility with a slow and unbalanced global economy. Its just tough to bet on an accident happening, because by definition timing an "accident" is quite unpredictable.

Short Term Stuff

In this morning's opener I outlined why this move may not be done in the intermediate term. I now would like to address why, even if we do go higher, we really should get a pullback first. Markets rarely go anywhere in a straight line and there are usually corrections within larger moves.  From a price, time and sentiment perspective there are certainly reasons to expect a pullback soon.

This morning's S&P 500 futures were 100 points higher than the lows seen a few weeks back and there have not been any real pullbacks the entire way up. From a time perspective the market has been rallying for the better part of over three weeks, which is a long time to go without a pullback. Typically markets show signs of exhaustion after two weeks. We have seen bouts of heavy call buying in the past few days and individual investors are as bullish as they have been in years.All these factors argue for some sort of pullback. A break over 1130 might be necessary to get the last holdouts back in the pool but its difficult to see much upside after that.

Even if the market does manage to rally a few more days, the end of the month will see huge secondaries from both Petrobras and Deutsche Bank, amounting to over $40 billion. If the exhaustion does not get to the market first, I suspect the supply will.

Why Stocks Are Going Up

Many are baffled by the continued rise in the stock market as the economy is clearly slowing. The stock market is governed by supply and demand, not by the economy. Recently we have seen heavy demand for shares from corporations. Off the top of my head I could think of the following share buyback announcements just in the past week or so:
  • RIMM announced that they bought back $1.5 billion worth of shares over the past quarter, amounting to well over 5% of their outstanding shares.
  • Texas Instruments announced a $7.5 billion buyback
  • Mastercard announced a $1 billion buyback
  • HP announced a $10 billion buyback after announcing that they already repurchased over $3 billion worth of shares this quarter
  • Bloomberg reported that Microsoft is about to issue debt to fund share repurchases.
There has also been some cash M&A activity and credible reports that there is more in the pipeline. At the same time portfolio managers have de-risked, leaving fewer people to sell. I believe that portfolio managers are now on the chase but still have plenty of room to buy before they are no longer underweight equities.

A slowing economy will eventually effect corporations cash flow but it will not happen as quickly as in the past cycle. There is simply not as much overcapacity and excess inventory to cut as companies are already running pretty lean.

This leaves investors at a tricky juncture where stocks are not terribly attractive based on valuations or the economic outlook but supply and demand characteristics are favorable.While I took a very small step to the short side yesterday, mostly because of short term considerations, I believe it pays to wait until portfolio managers once again turn optimistic and raise their equity allocations before taking on large short positions.

Make No Mistake

In the past couple of days Nucor and Fedex have said that business is slowing. While the CEO of Time Warner  Cable has said that business is slow as well. The economy is so bad that it is effecting cable subscriptions. What would Homer Simpson say? Make no mistake about it, the economy is weak. However, the economy and the stock market are not the same thing. I still expect a marginal new high above 1130 on the S&P 500 even if we pull back first.

First Time In A Long Time

I have  a small starter short position in the SPY.

Ready, Aim ....

The call buying is continuing. I am looking to short a starter position in the SPY near 112.8. I'm not sure we will get there again though.

Lethal Combo

We have call buying in the early going and a weak market. That is not what the bulls want to see. The market has trained participants to buy the dips. While dip buying has been working recently, typically once everybody catches on it is late in the game.

Patience Is A Virtue

Warren Buffet has said there are no called strikes in investing. The best opportunities are when market participants push things too far and emotions become extreme. If one uses all his ammo before that occurs than one cannot take advantage of those situations. Of course that means missing some moves, which I am happy to do. A good night's sleep is an undervalued commodity.

Seemingly Conflicting Signals

The American Association of Individual Investors survey is out and there are over 50% bulls, the highest reading this year. Yesterday, the Investor's Intelligence survey was out and bulls were at 36.7%, which shows a different picture of more neutral sentiment. It even could be described as on the bearish side.

The discrepancy between the two surveys is that the respondents to the AAII survey tends to flip depending on which way the wind is blowing and the II survey tends to represent medium to longer term sentiment.

These two seemingly contradictory readings actually jibe well with my view of sentiment. The medium term players like hedge funds are still positioned conservatively, albeit less so than a couple of weeks ago. While shorter term momentum guys are on board.

This makes for a tough decision as short term sentiment is too bullish but medium term sentiment can still fuel further gains. Some sort of breakout above the widely watched 1130 level would likely serve to get people into the bull camp quickly. If that were to occur going short would be an easy call. But right now there are no easy answers.

Won't Back Down

Can we still start a correction this week or do we need to wait until after expiration so all the downside protection can expire worthless? I don't know the answer to that question, but if we don't see a pullback before expiration, the odds of a post expiration hangover will be very high. This is not a market for guppies. Have a good night.

Swimming With The Sharks

Etrade reported today that August trading volume was down 36% from the same month a year ago, even though client assets were up over that same period. Individuals have largely stopped trying to beat the market. For the most part the market now consists of the sharks and the Great Whites.

Tops Are Processes

On rare occasion have we seen a spike top in the past year. Most tops have been sideways affairs, followed by a drop. I suspect this is because dip buyers must first use up their ammo and the bears with little conviction (short side renters) need to be shaken out.

Wrote Amgen Covered Calls

I wrote the October 57.50 covered calls on my Amgen position.

Softened The Hedges

On Monday I sold my position in the XLV, but I kept on the related hedge. I used the opening weakness to soften my hedge.

The Importance Of Following Hedge Funds

In the past few years hedge funds as a group have had wild swings in their net equity exposure levels. While there is no way to know the exact numbers, I have seen surveys that showed numerous swings of 20% to 30% in their net equity exposure. On a base of over a trillion dollars that is a lot of movement. Not surprisingly those swings coincided with movements in the market in the same direction.

Mutual funds might control more assets than hedge funds but changes in equity exposure are a lot smaller and happen at a glacial pace, so the effect of their equity allocation on the overall market is minimal. Individual investors have in large part shied away from the market. That leaves hedge funds as having the largest influence on the short term direction of the market.

Since May the buzzword in the hedge fund world has been de-risking and hedge fund surveys and performance have served to confirm that hedge funds have indeed been doing that. But when the market participants with the  largest influence have already sold, who is left to sell?

The fact that hedge funds have de-risked was the largest reason I was very bullish a little over two weeks ago and the largest reason I am hesitating to go short now. A few readers have focused on my statement that I am careful going short into the holiday season due to the seasonality. But the main reason for my caution is the fact that hedge funds have de-risked. A perceived year end rally would just be a possible excuse for them to justify re-risking.

What Type Of Pullback

Let's assume that we do get a pullback either this week or after expiration early next week. What type of pullback is it likely to be?

While the fact that the market has become so overbought is a negative in the short term, it typically signifies underlying strength and means that there is a good chance we at least retest this area again after a pullback. Additionally, hedge funds have de-risked and there are likely a lot of underperforming eager beavers ready to buy the first dip.

The bears can make a case for something bigger. The Deutsche Bank and Petrobras offerings in the coming weeks will mean over $40 billion in new supply and thus far there has been a lot of talk but no mega mergers to offset the supply. Additionally, momentum based quant algorithms have been pushing the market too far in whatever direction the market happens to be going in, so breadth readings are less reliable.

I am leaning towards the idea of a shallow pullback followed by another rally. That is a large part of the reason I am hesitating in going short. I do expect a pullback at some point soon, but I'm not expecting that much from it so I want to make sure that I at least get a good entry point.

Run For The Roses

Stocks are making a run for the roses and this marks nine out of ten days with positive breadth. That is extremely overbought and almost always leads to a pullback. I will be going net short tomorrow if we gap up. Have a good night.

Extreme ISE

The call buying at the ISE is extreme and the odds of a pullback are rising.

If You Don't Like It Than Piss Off

I always thought that the discussions in the comment section of the blog were very valuable as they allowed us to debate, discuss and consider new ideas. However, a very small minority of comments are simply geared at being mean, venting or proving that I am a moron and are of no value towards the process of making investment decisions.

If you are in a bad mood, your spouse pissed you off, you woke up on the wrong side of the bed or lost money than I feel for you. But please do not take it out in the comment section of the blog. If you think I am a moron than you can have your money back and not read the blog. All comments of a mean spirited nature will be deleted from now on.

Risky Business

This move is starting to get frothy, as it feels like stops are being run and 1-800-GET-MEIN is being dialed. I am strongly considering fading this move. Every time I try to get out they drag me back in.

Sideways At Best

The market can get a little more overbought if it has an up day today. However, after that it would be maximum overbought with 9 of the past 10 days being up. Even during the historic rally off of the March 2009 lows when the market became maximum overbought it paused for a few days at minimum before resuming its run.

The market has gone up enough to start causing some serious performance anxiety for hedge funds, which have largely de-risked and are likely underperforming. But even if the market is headed higher there will likely be a better entry point once we work off this overbought reading. The upside should be limited for the next week or so.

Net Neutrality

I moved from being partially hedged (or moderately long) to market neutral today. The bulls are probably better off with a consolidation before trying to get through the August highs. If they just blast through this week than there is a good chance it will be a pop and drop. My desire not to go net short will be sorely tested under that scenario. If on the other hand there is a consolidation followed by an attack on the August highs there is a much better chance that it will hold. Have a good night.

Still Don't Want To Short

In my earlier post I outlined why I believe it pays to err on the side of caution and why I believe we are likely to get a better entry point in the coming weeks. That said, I am still not thrilled with the idea of trying to short this market either. Hedge funds have de-risked and if they decide to re-risk because of a perceived Republican victory or a perceived year end rally the market will likely go significantly higher. The performance anxiety is percolating.

There is also the possibility of a mega merger wave given high cash balances at mega cap companies and record low rates. Additionally, I have been burned too many times on the short side heading into the New Year to not respect the seasonality. That doesn't mean I am unwilling to short heading into the New Year but it does mean I am extra careful.

Supply and Demand

In the coming weeks we are going to see a $12 billion offering from Deutsche Bank and a $30 billion offering from Petrobras. There is a chance we will see some cash M&A to offset the supply but thus far there has been a lot of talk and little action.

Clowns

How does one justify being bearish two weeks ago when the S&P 500 was over 80 points lower and bullish today at 8% higher levels? Watching the market reminds me of the circus with clowns piling into a bearish car, only to notice that the car is too full so they all head for the bullish car.

Sold XLV

I have sold XLV, the healthcare ETF, into this higher open. The ETF is heavily weighted in pharma which has outperformed recently. I now believe there are better opportunities within healthcare. This move brings me to a roughly market neutral posture.

The Slow Motion Slowdown

The current slowdown is very different from the ones seen in 2000-2003 and 2007-2009. In both cases there was a lot of leverage by market participants heading into the slowdown and corporations had a lot of excess capacity and excess inventory. Currently neither is true as market participants are positioned conservatively and corporations are running pretty lean.

Investors have been rejoicing at the recent data because it has been less worse than feared as some braced for a double dip that mirrored the experiences of the past decade. Investors might want to wait before sounding the all clear as the economy is still slowing albeit at a slower pace than investors have gotten used to. Stimulus is wearing off causing municipalities to shed jobs and causing a renewed slowdown in the housing market. Production is slowing as inventories have been rebuilt but final demand has not picked up. But the drop off is not as sever as in previous slowdowns because we are starting from low levels.

Relying on experience of the past decade to navigate the current market and economy is a mistake. I believe the best course of action is to fade the excitement when investors think the economy is improving and fade the gloom when investors believe we are in for a collapse similar to those seen in the past decade.

If Thats The Good News

Markets seem to be quite happy about the new Basel rules. It is a positive in the longer term if the World's banking systems are sound and less levered. However, the medium term effects of this will likely be negative. Many European banks will need to raise equity, like Deutsche Bank is planning to do. Equity raises are a source of supply for global equity markets. Additionally, credit growth will likely be sluggish as banks try to lower their leverage ratios.

Overbought At Last

The market is currently overbought in the short term as shown in the chart below.
The 10 day moving average of the NYSE Advance-Decline line will be dropping positive numbers in eight of the next ten days as shown below
Sentiment is not giddy but is much improved from two weeks ago. The AAII survey is showing more bulls than at any time since April. The Investors Intelligence survey is showing more bulls than bears, but is nowhere near extreme and can be interpreted as neutralish. It has been difficult to decipher a message from the put/call ratio recently.

New 52 week highs on the NYSE lagged badly on Friday even though the S&P 500 made a new high for the current run. Many of the recent new highs have been in bond funds and preferred shares, which are interest rate sensitive. The recent rise in rates might be behind the deterioration in new highs but taken at face value the deterioration is a negative. NASDAQ new highs lagged as well on Friday, which are less sensitive to interest rates.

If one really tries hard to be bullish one can note that we will still be dropping a large negative number from the Advance-Decline line tomorrow, so its possible that we can get a little more overbought. Additionally, option expiration, which is Friday, often serves to perpetuate a trend.

I would note that even if we do get a little more overbought that chances are that when we finally do work off this overbought reading there should be better levels to buy at.  I believe at the current juncture it pays to err on the side of caution.

Capital Observer Will Return Monday

The market remains sans an easy trade, although we are closer to being overbought and short term sentiment is moving towards bullishness. I will return Monday. Have a Happy New Year and a great weekend.

European Bourses Nicely Higher

I am on high alert for problems from Europe, so it is nice to see that European markets closed solidly in the green. While I am a little cautious in the very near term I have a hard time seeing much downside short of a crisis. I remain only partially hedged.

CBOE Equity Low

In addition to their being call buying at the ISE, the CBOE Equity only is also quite low and one can make an argument that we are overbought at the end of the day today. There should be better buy points.

House Cleaning

I have decided to reduce my risk due to heavy call buying at the ISE and the fact that I will be out until Monday. I bought back the naked SPY puts I sold yesterday. I also disposed of the Gilead I bought for a trade when the market was declining. Gilead remains my largest position by far. The Gilead I sold was only bought for a trade.

What Can Go Wrong

The biggest threat to the bulls is an economic accident and an accident is the only way I could see considerable downside in the next few months. Sovereign issues are the most likely cause of an accident. The EU raised money in order to help alleviate the funding crisis and still has a lot of firepower. While this might only push the problem further out in time I believe it will succeed in doing that and do not expect a crisis right now.

The sharp move higher in the safe haven currencies in recent days is somewhat disturbing and gives me some pause. If something does happen this will certainly be pointed to as the canary in the coalmine. This makes me more vigilant and on the lookout for possible issues but I am still not expecting a crisis right now.

Deep In No Mans Land

After today we are further away from getting a good overbought reading to act on. Pinpointing when we will be overbought is tough because we chopped along the bottom for a few days before we took off. Today's consolidation likely means it will take until early next week to get a decent reading. We are also not close to being oversold. If traders were expecting clarity after Labor Day there was none offered today. Have a good night.

Limited Downside

The market is concerned today about European sovereign defaults. I would point out that European markets did not fair all that badly today with the DAX and FTSE only down .6%. If contagion were to occur I believe they would be the first to sniff it out. Additionally, the market has not become maximum overbought. As such I believe any further downside will be limited. I sold some SPY 108 Puts expiring next Friday naked.

In Good Company

John Hussman's fund has handily beat the S&P 500 since inception. This is partially because he has hedged his exposure and partially due to superior stock picking. He has a greater than 30% weighting in health care, which is a huge overweight for a mutual fund. I am happy to be in his company.

Grain Of Salt

My entire portfolio consists of stocks with little economic sensitivity. My largest holding by far is Gilead Sciences, which generates the majority of its revenues from AIDS drugs that keep people with HIV alive. Recession or depression, HIV patients need these drugs. Gilead will likely earn its market cap ex-cash in the next six years. So when you read that I am net long please be aware of what I am long. I am hardly a raging economic bull.

Short Term Agnostic

The market is not yet maximum overbought. A better sell setup would occur if the market became maximum overbought.  By the same token there will probably be a better buy point when the market works off its overbought reading. I am sitting on my hands and will wait for the bulls or bears to over reach. I remain only partially hedged.

Bull Vs Bear: Part 2 The Bull Case

In the first part of this two part series I looked at the bear case through the end of the year. I will now look at the bull case:
  • Cash M&A and Buybacks-Many companies have a lot of cash on their balance sheet and the corporate bond market is practically begging them to take more. This has led to a pickup in share buyback and M&A activity. This has the potential to be a massive plus for the overall market. Just the Potash and Genzyme deal would likely amount to $70 billion of cash entering the market. M&A is like a fever. When CEOs see other CEOs getting new toys and they want one too.
  • Sentiment- Longer term sentiment measures are quite negative, which likely means that most people already acted on their bearishness. Should sentiment somehow turn positive their is a long way to go before people become fully invested. Most importantly hedge funds have de-risked leaving limited room for them to sell and a lot of room for them to buy. They move their allocations quicker and in larger steps than any other group so I believe they are the most important group to follow even though they are not the largest. For instance, mutual funds represent a larger group but their cash allocations change at a glacial pace. 
  • Seasonality- While seasonality is negative for the next few weeks it will be very positive through the end of the year. 
  • Gridlock- Many view a Republican victory as a win for business. That could be the spark needed to turn sentiment.

Bull Vs Bear: Part 1 The Bear Case

The intention of this two part post is to step away from the day to day and explore both the bull and bear case through the end of the year. In the first part I will explore the bear case.
  • The heightened potential for an economic accident- Economic accidents tend to happen when the economy is slowing and their are plenty of imbalances out there to cause an accident.
  • IPO and secondary pipeline is quite full- Petrobras wants to do a greater than $30 billion secondary offering, while GM is looking to do an IPO of at least $15 billion. The government still has over $10 billion of Citigroup shares to sell. The IPO pipeline is quite full with private equity companies looking to bring back the LBOs of the past bull market like Toys "R" Us and and HCA. 
  • Record low cash levels at mutual funds- Since July cash levels have fallen to record low levels at mutual funds. It seems that mutual funds have been meeting withdrawals with cash.Cash levels are so low that further withdrawals will almost certainly need to be met by selling stock. Even if mutual funds have inflows they might use it to shore up their cash positions rather than buy stock.
  • Hardship withdrawals- Municipalities have been neglecting contributing to pension funds. As a result pension funds are dipping into assets in order to meet obligations. Additionally, I believe a large part of the recent withdrawals from the market have been due to people dipping into savings. With a weak job market that is set to continue.
  • The 99ers are running out of benefits-Unemployment benefits have been extended to 99 weeks. Even so 3 million people are expected to use up their 99 weeks between now and January. This will be an additional headwind for the economy.
  • Political risks-Republicans and democrats are so far apart on how to help the economy that it will be difficult to get additional stimulus if it is needed. There is the potential for the expiration of the Bush tax cuts which would not help psychology.

The Fear Of Missing

The bears could take solace in the fact that if we rally Tuesday and Wednesday we will likely be overbought. I would likely further hedge my portfolio if that scenario plays out.

The reason I was able to get aggressively long at the most recent bottom was because I waited for the market to become oversold before doing the bulk of my buying (mainly removing my hedges). When I go short I try to exercise the same patience.  That patience means that I will miss tops where we do not get fully overbought but it also saves me a lot of pain. I used to hate missing moves but over the years I have managed to get over it. The fear of missing is an investors worst enemy. Have a great weekend.

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A Risk Of Inflation

I admit that I am not smart enough to know how the inflation/deflation debate will ultimately play out. We are in unprecedented times and anybody that claims to know for certain is a fool or a liar. A large part of the reason that inflation has been kept under wraps for the past decade is global labor arbitrage.

Food prices are starting to become an issue in the countries where there is cheap labor. If food prices continue to rise, cheap labor will cease to be as cheap. If the price of grain goes up so do cattle prices. From the Associated Press via Yahoo!:

China's food price inflation spiked to 6.8 percent in July over a year earlier, pushing overall inflation to 3.3 percent, its highest level this year, according to government figures.
Elsewhere, a jump in food prices triggered deadly riots in Mozambique this week and the poor in Asia, the Middle East and Africa are under strain after global prices jumped 6 percent in the past two months alone.
No unrest has been reported in China but food prices are politically sensitive in an economy where the poor majority spend up to half their incomes to eat.

Are Hedge Funds The New Dumb Money

Are hedge funds the new dumb money? I posted this a few days ago  but its worth reposting. From Marketwatch:
Hedge-fund managers have become more bearish on equities because they're concerned about slowing economic growth, according to results of a recent survey released Monday by TrimTabs Investment Research and BarclayHedge.
...Hedge-fund managers continued to favor U.S. Treasury bonds. In August, 36% of those surveyed by TrimTabs and BarclayHedge said they're bullish on the 10-year Treasury bond, up from 34.5% in July. Bullish sentiment jumped to 36% from 14% in the past two months. 

Not Interested In Going Short

Heading into the seasonally weak time of the year in May I was very bearish as sentiment was giddy, but we will now be heading into the seasonally strong part of the year in a few weeks with sentiment a lot more subdued. Hedge funds have largely de-risked and individual investors have done the same. As a result I have little interest in trying to short the market unless all the ducks are lined up.

I have been burned too many times shorting during the seasonally strong times of the year to not take seasonality into consideration. This does not mean that I will not go short, but that everything will need to line up for me to do so. The market will need to be maximum overbought, preferably on a short term and intermediate term basis. Sentiment will need to be extreme. This does not mean that I will necessarily be long, as it is possible I will partially or fully hedge my portfolio.

Not Chasing But Not Shorting Either

The S&P 500 has had a 50 point run in a straight line and I would not chase this strength. But I would not go short either. The market is not yet overbought on a short term basis as you can see in the chart below.
Below are the numbers we will be dropping for the next ten days off of the 10 day moving average of the NYSE advance-decline line. As you can see we will be dropping negative readings for the next three days so the market will not be overbought until the end of day on Wednesday of next week at minimum. The reason I say at minimum is because after that we will be dropping choppy numbers for a few days and its possible that the rally can last into the week of expiration, although I doubt it would make much more headway if it managed to rally through Wednesday.

Capital Observer Will Return Friday

Today's rally has helped relieve the oversold condition and reduced the excess bearishness. However, the market will not be overbought until next week and market participants are still positioned very defensively. I still favor the upside but with less conviction, hence the partial hedge that I put on today. I will be out of the office tomorrow and return Friday. Have a good night.

Sometimes The Crowd Is Right

I find that when sentiment is extreme it generally pays to fade the crowd. There will be times when this strategy fails but far more times when it succeeds. Times like late 2008 and early 2009 are the exception, not the rule. One must accept that at times it will prove to be a losing strategy and the losses might not be small. But over the long haul I believe it is the best strategy out there despite it going against all trading conventional wisdom.
  • The trend is your friend
  • Dont fight the tape.
  • Cut your losses.
  • Don't try and pick bottoms.
  • Etc. etc.
Even if one decides to be a contrarian it is  a lot easier said than done because one really needs to believe in this strategy in order to execute it. Most of the time one will not catch the exact bottom or top and the trade is likely to start out with a loss as momentum rules in the short term. The reason there will be a strong consensus is because the arguments will sound so good. It is very difficult not to get sucked in, especially because we are just overgrown primates hardwired with a herding instinct.

Another challenge of the strategy is that it is very difficult to gauge sentiment. There is no perfect indicator out there so one must always be on the lookout for clues. Sometimes an indicator won't work, so one must weigh the weight of all the evidence and not get stuck on a single indicator. Because there is a large amount of subjectivity involved it is difficult to make sure that ones bias is not coloring their outlook.

Yes, when there is a strong consensus the crowd is sometimes right. But I'll take the other side of that trade any day.

Day Tripper

I have partially rehedged by selling the SPY November 108 Calls naked.

Now That's Exreme

The Investors Intelligence survey is out with bulls under 30% and bears at nearly 38%. Both are post March 2009 records. Can everybody be right?

Definition Of A Crash

By definition a market crash is less likely to occur when the crowd is expecting one. A crash occurs when panic leads to too many people heading for the exit at the same time. If the crowd is expecting a crash than they sell ahead of time, buy protective puts and even short. That makes it less likely that anybody will need to sell in a panic as they are already protected.

Hedge fund managers have derisked and individuals are about as bearish as they get. There are articles everywhere about how bad September has been historically, how the economy is double dipping and there areprice targets on the S&P 500 under 1000. With all this preparedness it is a lot less likely that we will see major downside.

There are global imbalances that could cause an economic crisis. I believe it would take  a crisis in order for the market to see major downside in the near term. I am not writing off the bears concerns as they do have good points. But these concerns have been true for over a decade and there have still been plenty of rallies.