Happy New Year

Have a happy, healthy, profitable New Year.

2011 Post Mortem and 2012 Outlook

The S&P 500 is sitting in nearly the same place it was one year ago but much has changed. S&P 500 earnings for 2011 are likely to be 15% higher than for 2010 once the final numbers are tallied, hence valuations are significantly better than they were at this time one year ago. A year ago sentiment was giddy on "The David Tepper Win-Win Rally" and investors were aggressively positioned. Today, investors are scared and positioned conservatively.

One year ago investors were heavily overweight cyclical sectors while shunning utilities, healthcare and consumer staples. Cyclicals are showing large losses for 2011 while defensive groups are showing large gains. I don't believe sector positioning is as lopsided as it was a year ago but it seems investors are slightly tilted towards defensive sectors now.

Valuations are attractive and investors are positioned conservatively, which is generally a good combination for a higher market. However, there are huge imbalances in the global economy that cannot be ignored. Valuations  are pricing in some turmoil as earnings would be able to miss expectations by 10% and the S&P 500 would still be reasonably priced. However, a large scale disaster is not priced in and the potential for one exists.

Heading into 2011, I was not very optimistic about the market or the economy. The giddy sentiment and global imbalances worried me. I believed the economy would slow. The economy performed as I expected but corporate profits performed much better than I could ever have imagined given a slowing economy. A combination of my bearish outlook and excellent valuations  had me positioned in defensive sectors, with my largest holdings being in healthcare.  Being positioned in defensive sectors made my year.

Heading into 2012, I am not very optimistic about the economy but valuations make me somewhat constructive on the market.  In the early part of the year I am planning to maintain a medium sized net long posture (short term trades not included). I will be reluctant to get aggressive other than for short term trades given all the imbalances in the world economy. I still like select defensive stocks like Vodafone, given the still good valuations and slow economy. I also like certain cyclical stocks such as in  software, where valuations are already pricing in a lot of pain (ORCL, CA, BMC).

 

Very Positive Seasonality vs. Overbought

The final trading day of the year has not been very friendly to investors with the S&P 500 showing losses in 6 of the past 7 years. However, the first couple of trading days of the year have been very strong outweighing the final day of the year.

We have an overbought reading but the market has the potential to get more overbought in the coming days. Looking at the 10 day moving average of the advance-decline line we could get more overbought through Wednesday. Looking at the 10 day moving average of the put/call ratio, we could get more overbought through Tuesday.

A strong move early next week would have us overbought and looking at more neutral seasonality. That would likely be  a decent place to pare back some exposure.

Monti Speaking Up

Italian Prime Minister Mario Monti spoke up today about the high interest rates that Italy has to pay. He very clearly asked for more help. This is significant in that this is the man that the ECB and Germany have backed (unofficially). He  is likely the most friendly possible Italian PM to the causes of reform and austerity. Italy has done what was asked of them and is now asking for something in return. This is a step in the right direction. the first step in receiving a bailout is asking for one.

The End Of The World Has Been Delayed

Much to the chagrin of the Zero Hedgers, the end of the world has been delayed yet again. The Italian bond auction was not great  but is now in the rear view mirror and likely to be forgotten in a few hours. The strength in the dollar and weakness in precious metals are putting some pressure on the "risk on" trade. The strong dollar trade is likely being exacerbated by year end.

The market will be overbought at the end of the day today but can get more overbought through Wednesday of next week. Seasonality remains very positive although we have seen weakness on the last day of the year the past few years. Had we rallied through today I would have reduced positions. However, I believe yesterday's correction is setting us up for one more move higher before a better overbought reading.

The Big, Bad Italian Bond Auction

The world is fretting about the Italian bond auction tomorrow morning. It will very likely not be good. However, once it is behind us there will no longer be anymore big, bad events to fret over in 2011. I expect one more rally late this week or early next week. Have a good night.

Losers Lose, Winners Win

The winners from 2011, namely staples and healthcare, have recently accelerated their outperformance. While the losers from 2011, everything else, continue to suck wind. Generally, the losers outperform early in the new year as  tax loss selling and window dressing end. This effect is seen most in small cap stocks and is known as the January Effect, but applies to a lesser degree to large cap stocks as well. For some of my stocks the new year can't come fast enough.

Slightly Longer Again

I have gotten slightly longer for the second time today.

Slightly Longer

I have used this move lower to get slightly longer. I think there is one more move higher later this week or early next week.

Nearing Overbought

The market will be overbought at the end of the day tomorrow. It is possible it will take until Wednesday of next week before we get maximum overbought. But the strong tailwind of the oversold reading from from early last week is clearly ending tomorrow.

Given the seasonality I am inclined to give the market the benefit of the doubt for as long as possible. This is proving difficult because the market has gone straight up. Typically when a market goes from oversold to overbought there is a dip somewhere in between but we have not seen one.

If we were to rally through tomorrow I would be inclined to reduce positions. However, if we were to see a pullback I would be more inclined to give the market until the middle of next week.

Defense Over Offense

The underlying theme in the market remains defensive stocks. As readers know by now I believe this theme is going too far. Colgate trades at 17 times forward earnings, while Oracle trades at less than 9 times (net of cash). Colgate deserves a premium because of the steadiness of the business but does it deserve double the multiple of Oracle? Have a good night.

Bought Oracle

I started a position in Oracle. This is a market neutral trade as I hedged it with an S&P 500 short.

Digestion

In my opener I noted a possible negative divergence in the number of new 52 week highs on Friday. We are already seeing as many new highs today as we did this entire rally. This negative divergence is now gone.

My Answer

I have been asked many times in the past few weeks why I concentrate on the fact that large investors, especially of a hedge fund kind, are underinvested? After all, they have been underinvested for a while and the market has not been able to make much headway.

The first thing that one must understand is that even the so called smartest investors in the world are illogical. Higher prices turn people bullish even if little has changed fundamentally. At some point these larger players will be forced to chase the market. Being underweight ones benchmark feels like being short when the market is rising and the easiest way to make the pain stop is to buy.

I don't know where this magical level is that will force these large investors to capitulate and buy but I know its there. I have seen it time and time again. I don't know if we will reach that level but the risk that we will is out there. When large market participants are bullish, like they were early this year, this upside risk does not exist because they are already overweight equities. For this reason I have no desire to go to a net short posture even if we were to get overbought and see a little too much bullishness. At most I would be willing to go to a neutral stance.

Bulls Maintain Slight Advantage

I still believe the bulls deserve the benefit of the doubt but there are some cracks starting to show in the rally. The number of 52 week highs was lower on Friday than on Thursday, even though the market closed well higher on Friday. The reason for this was likely the narrowness of the advance on Friday as the strength was concentrated in the most defensive sectors. The most bullish thing the market could do is consolidate and see some sector rotation as other sectors catch up to the defensives.

A rally generally starts showing some divergences before it fails. This is only the first sign that the rally is starting to tire. The positives are that seasonality remains very strong, the market will not be overbought until later this week or early next week and that large market participants remain underinvested. I still believe the bulls have the advantage but we are no longer in the early innings of the current rally.

Merry Christmas

I am calling it a week. Happy Hannukah. Merry Christmas.

Winds Of Change

The biggest anomaly I see is the discount that safe stocks trade at compared to economically sensitive stocks. It seems like a no brainer to be in defensive stocks.

I wrote the above on February 25, days before defensive stocks began to massively outperform economically sensitive stocks. While my quote was timely, I was early in positioning myself in defensive stocks as I had been suffering in them for months prior. I had to watch economically sensitive stocks shoot to the moon while my holdings languished. Eventually, I was paid in spades but it was not easy to stick with my conviction as the market told me I was wrong every day.

We are now seeing the complete opposite as defensive stocks shoot to the moon while economically sensitive stocks languish. I am not very optimistic about the economy but at some valuation difference it makes sense to own software instead of consumer staples.

I am slowly shifting some of my exposure from more defensive, staple like companies to software. I realize that I am likely to be early again as stock market participants never learn and always take things too far. But I know that I will not be able to pick the exact turning point either. This does not mean that I don't believe defensive stocks have a place in one's portfolio. They still have a large place in mine. I am just now willing to have more economically sensitive exposure because the price is right. I'm also willing to part with my defensive holdings at the right price.

Frustration 101

There are many parts of trading and investing that are frustrating.  But there are few things more frustrating than being long and not making money when the market is going up. This is precisely what has happened to me in recent days.

I have a healthy weighting of software in my portfolio, which has gotten killed since Oracle reported earnings. In the meantime the market has risen. I am sitting on a loss for the past three days while the market is rising.

I have been trading for a long time and have learned to control my emotions, but this is one I cannot get over. I logically understand that as a stockpicker and a contrarian this is bound to happen. In the end I'm just an overgrown, emotional primate.

Using The Strength

Some of my more defensive holdings are popping today. I used the strength to trim them a bit.

Forget Logic

We are once again gapping up despite Italian 10 year yields near a record. I would not chase this move but I would not short it either. I have battle wounds from trying to fight the market during these thin holiday periods and have finally learned my lesson. Unless we are at sentiment extremes, I either go with it or sit out. Logic is not for thin holiday sessions.

 

Tom Demark's Latest Video

This is Tom Demark's latest video with Bloomberg.While I don't trade based on his work I like that he makes big, against the grain calls.

Change

We saw a big change today in that Italian 10 year bond yields blew out to a near record and the stock market did not blink. Is this sustainable in the long term? No. But there is no reason the market cannot cause harm to all the under invested, underperforming managers out there until New Years. For now, I am willing to play along but I would feel much better about being long if the ECB would deal with the issues. Have a good night.

Mixed Feelings

The statistics argue for a continued rally in the stock market. The market will not be overbought until around New Year's and seasonality is very strong at this time of year. That said, we have just had a large move and are gapping up again today so we could see some give back in the short term. While we could see some short term weakness, I believe the market deserves the benefit of the doubt until the New Year.

 

Change Of Heart

One of my themes coming into 2011 was that "defensive" sectors were undervalued versus "risk on" sectors. We have seen a complete about face and I believe that some "defensive" names are starting to look a bit pricey, while some cyclical sectors like software are starting to look cheap. I will be looking more closely at this in coming weeks. These trends tend to overrun so calling a turn is tricky. Have a good night.

Who's The Sucker

Say what you will about Larry Ellison but the man is not a sucker. Earlier this year Oracle was a consensus long and the stock traded over $36. Larry Ellison, the Oracle CEO, thought software stocks were expensive and built up cash. At the time Oracle repurchased virtually none of the their own shares.

Yesterday, Oracle went from hero to goat and the same people who loved Oracle at $36 hate it at $25. In conjunction with earnings Oracle announced a $5 billion repurchase plan in addition to their existing $2 billion authorization, signalling they want to be buyers of the stock at these levels.

On one side of the trade we have the reactive investing public and their reactive money managers. On the other side of the trade we have Oracle headed by self made billionaire Larry Ellison. Who is the smart money?

 

Sold Some Walgreen's

I sold some Walgreen's common stock that I was long after the stock has jumped nearly 5% from this morning's lows. On net I have more exposure to Walgreen's than coming into the day, due to my earlier trade.

Neutralizing CVS

I bought CVS Puts which neutralizes my long exposure to the stock. CVS has come a long way and could see some downside if Walgreen's settles with Express Scripts. I still like the stock longer term but prefer Walgreen's because of the valuation.

Walgreen's Risk Reversal

I sold April 28 Walgreen's puts to buy April 34 Walgreen's calls. The reason I like this trade is that I would be willing to own Walgreen's at $28 regardless of the outcome of the dispute with Express Scripts. I remain of the belief that they will eventually settle.

Oracle Highlights Investors Dilemma

While Oracle's earnings last night disappointed, I believe Oracle is a  microcosm for both the bull and bear case for the broader market. The bear case is that earnings is a lagging indicator, but eventually the macro will catch up with earnings. Oracle was able to keep earnings up while global growth slowed but eventually gravity set in. Bears will argue that macro headwinds will only worsen as will earnings.

The bulls will point to the fact that despite the earnings disappointment, earnings are still growing. Oracle now trades at less than ten times forward earnings estimates, once one considers the $3 of cash per share Oracle holds. After building cash for years, Oracle announced a $5 billion share repurchase plan last night. The savvy Larry Ellison was not interested in repurchasing shares when they traded above $36 a few months back but at $26 he is a buyer.  Investors should follow suit and buy low for a change.

I am torn by both the bull and bear arguments as they both have merit. I believe that one can only buy cheap when the news is bad and buying cheap is the best predictor of long run returns. At  the same time I recognize the unprecedented headwinds. Oracle's earnings exemplifies the dilemma that investors face. The debate goes on.

Happy Hannukah

I believe that today was the first day of a year end rally. However, after a 3% rally the the risk/reward is not as favorable as it was yesterday. Happy Hannukah. Have a good night.

No Guts, No Glory

In order to participate in today's advance one had to either buy into yesterday's despair or buy into a big gap up, in a time when gap ups have been failing. Neither was easy. The market for the past few months has been a  no guts, no glory market.

Oracle Earnings On Deck

Oracle is set to report earnings after the close tonight. Oracle trades at less than ten times forward estimates once one nets out the cash on their balance sheet. This is amazing for a company that has a virtual monopoly in databases. Databases are likely to be needed in the future.

I am very tempted to buy Oracle but there are two things that are holding me back. The first is that I have  a lot of exposure to the software space via BMC and CA. The second is that Oracle is unclear about their capital allocation plans. I like to know what companies I own plan to do with their money. I am somewhat comforted by the fact that Larry Ellison has been a good allocator of capital. I am very seriously debating whether to make a purchase.

Gift Horse

I made some sales. I am not looking a gift horse in the mouth.

What A Difference A Day Makes

It appears the year end rally might finally be under way. While we have seen many false starts in the past week, the underlying conditions for a rally have improved. For starters we are finally oversold. We could get more oversold in the next couple of days but I don't believe we would undercut yesterday's lows by much as time is running out.

Looking at yesterday's put/call ratios and Rydex data one does not see much fear. Anecdotally, I saw widespread fear and despair late yesterday. Normally, I would tilt towards going with the the numbers, but the level of disgust I saw late yesterday with the market was so high that in this case I am trusting my instinct.

To summarize, sentiment is negative, the market is just about oversold and seasonality is positive. I think I am starting to see Santa Claus on the horizon, although he looks a little thinned out due to the austerity program the ECB forced upon him.

Little Miss Sunshine

The good news is that we are finally oversold and sentiment has turned very sour. The bad news is that the market has the potential to get more oversold through Wednesday and that the ECB is unlikely to take King Solomon's sage advice. Have a good night.

Holding My Nose

I held my nose and started doing some buying but I am leaving room.

Please Just Shut Up

"Better to remain silent and be thought a fool than to speak out and remove all doubt"

-King Solomon

Past rallies have been built on the hope that the ECB might wake up and realize that they are the only possible buyers for European peripheral debt. After recent speeches it is difficult to fathom this occurring as they have displayed how utterly clueless they are. It will likely take  a worsening of the situation in order for them to act.

I believe the market is set up to rally into year end but the ECB is making it a challenge. It is difficult to buy without even the hope that the situation in Europe could get better. That said, I still believe we will get a rally starting some time this week.

Zynga Is A Positive For The Market

As of this writing Zynga is down over 10% from where they priced their IPO. I view the decline in Zynga as a positive for the market for numerous reasons. This will lead to less supply in terms of IPOs and secondaries. Additionally, bubble like valuations are not long term positives for the market.

I view IPO's and secondaries as supply into the market. Last week we saw about $4 billion in IPOs and secondaries. $4 billion that could have gone into other stocks was needed to absorb this supply. In the future it will now be much more difficult for bankers to price their junkier supply. This should lead to less supply.

For every Amazon during the internet boom in the nineties there were 10 Webvans, Globe.com, etc.. During the internet boom everybody was being priced like a winner, even though the vast majority of the stocks went to zero or thereabouts. We are seeing a similar dynamic in social media. There will be winners but right now everybody is being priced like a big winner. Zynga is a video game maker that happens to make video games for social media. These video games are far less sophisticated than what companies like Electronic Arts make yet the valuations are not even in the same stratosphere. There are no barriers to entry and these games are relatively simple to make.

In the long run the only people who benefit from unsustainable bubble valuations are those selling and the bankers getting a commission. Investors that get burned no longer want to invest, whether they get burned directly or through a mutual fund. Hopefully, the fall in Zynga will lead to less junk supply from bankers and more rational valuations.

Is Santa Claus Coming To Town

I believe that we are setting up for a year end rally, but pinpointing where it will start is a bit of a challenge. The reason being that we have had a lot of choppy activity recently. The market will be at an oversold reading at the end of the day today, but it won't be a great reading. My preference is for a down day today that gets us more oversold and turns the crowd bearish. In the worst case we will have to suffer through another down week, which would leave us very oversold for the final week of the year.

It is difficult to argue that sentiment is bullish right now. The overarching sentiment that I am seeing is despondency. I do believe that we are closer to bearishness and another down day is likely to get us closer to excess bearishness. The secondary market is now closed for the year, so there will be no more supply via IPOs and secondaries. Europe is likely to continue to dominate market direction but barring a severe worsening of the crisid I believe further weakness can be bought into for a year end rally.

Wear Out or Scare Out

I believe we are getting close to a tradeable low as sentiment has soured, but we might need to see a little more weakness.  Have a great weekend.

Surprise, Surprise

A few weeks ago I wrote a post titled, Carl Icahn or Wall Street Analysts, which highlighted the divergent paths Amgen and Gilead were taking. Amgen was returning cash to shareholders via a tender offer while Gilead did a large acquisition. Wall Street analysts were downgrading Amgen and upgrading Gilead. Amgen has Carl Icahn on the board, who was clearly pivotal in Amgen's strategy.

It comes as little surprise that self made billionaire Carl Icahn triumphed and Wall Street analysts were wrong. Amgen is up 11% since the tender while Gilead is down 5% since their acquisition.

Brighter Outlook

Funding stresses in Europe have eased in recent days for peripheral countries. The Spanish two year yield is trading at a little over 3%, down from 6% not long ago. This is a big positive but the danger is that we have seen this before only to see stresses return when the ECB backs off. That is the reason that I took profits on my long trade from yesterday.

I remain at a medium sized net long position despite the sales I made this morning. I believe sentiment is a net positive for the market as hope at the beginning of the week has morphed into skepticism. Large investors are under invested, we are no longer overbought, valuations are reasonable and seasonality is positive. Europe is a big risk.  EU leaders are whistling past the graveyard but stop short of allowing us fall into the abyss.

Out Of Long Trade

I used this morning's pre-market strength to exit my long trade from late yesterday. I remain at a medium sized net long position.

 

Added To Long Side

I have added to my net long posture by removing some hedges.

Better Odds

This weekend I read numerous articles calling for a breakout in the stock market. In addition to my indicators flashing caution this was yet another canary in the coalmine I chose to ignore. Today we are seeing a CBOE equity only reading above 1.00 (a lot of put buying) which is generally bullish and it seems many bulls have given up. This is not the type of negativity we saw during Thanksgiving but I believe it is a short term positive for the bulls. I believe the odds continue to favor the bulls in the very short term.

Ignoring My Own Advice

At the beginning of the week I wrote:
In the short run we are overbought and will remain so through Wednesday. The overbought reading will likely put a lid on the upside in the early portion of this week.

Unfortunately, I did not heed my indicators as I did not expect a decline of this magnitude. Rather than go on another rant about the ECB I will focus this post on what my indicators are saying now.

The good news is that we are no longer overbought. Unfortunately, we are not yet at a good oversold reading either. The reason being that we had a lot of chopiness in recent weeks. In the very short term we should see a bounce as is usually the case after three hard down days. But both sentiment and the overbought/oversold indicators are not calling for much more. Once we get a bounce we will likely be back in no man's land in terms of short term indicators.

Retail Cashing Out

Over $5 billion left domestic equity mutual funds last week even though the market was higher. Week after week we have seen huge outflows from mutual funds. This is likely a large part of the reason so many growth darlings have been getting killed. Hedge funds don't generally own the stocks that trade at 50 times earnings. These are generally stocks that large mutual funds like Fidelity and Janus own.

Defying Logic

Every rally in the past few months has been pinned on the hopes that the ECB might wake up and realize they are the only possible buyers of peripheral debt. The ECB criticized peripheral nations for not doing enough in terms of austerity. It was not irrational to read between the lines and assume that in turn for austerity the ECB would lend a helping hand. Not only did the ECB not help but they lowered their bond purchases to next to nothing last week. They actually helped less in return for austerity

ECB officials are spouting utter nonsense on a daily basis. Their statements are the equivalent of saying that water is not wet. We are stretched on the downside so it is very possible that we will see a snapback rally. However, it is difficult for me to imagine the type of rally we have seen in recent months unless the ECB acts. Nobody is going to believe the ECB will act until they do. The boy has cried wolf one too many times.

I have been moving between a moderate to aggressive net long position in recent months. At the extremes I have become more aggressive and I have lightened up into rallies. I currently stand at a medium sized net long position and I am a lot more hesitant to increase my longs. Hopefully, this hesitancy is a good contrary indicator as I would still much prefer a higher market.

Guten Morgen

Futures were rallying overnight until German ECB member Jens Weidmann comments started to hit the newswires. Among them were:
ECB's Weidmann says losing AAA rating is not the end of the world

ECB's Weidmann opposes boosting bond buys, coy on IMF

WEIDMANN, ON IDEA OF UNLIMITED ECB BOND BUYS, SAYS FINDS IT ASTONISHING PEOPLE THINK CAN WIN CONFIDENCE BY BREAKING RULES

Weidmann:Preventative Intervention Via Bond Buys Unproductive

Weidmann Says Don't Think Aid Program Is Needed For Italy

The Euro promptly toppled and our futures followed when these headlines hit. The ECB continues to ignore reality with its idealism. This will likely change but the only question is how much damage needs to be done first. We should be approaching a rally shortly but it will be difficult for it to progress much as long as the idealism from the ECB continues.

I am remaining at a medium sized net long position because I believe the ECB will ultimately do what is necessary to stop a meltdown. However, in order to get more aggressive I would like to see them actually do something or I would like to see more extremes in the market.

Level Of Frustration

My level of frustration with Europe is very high. Everybody seems to know what the answer is except for the ECB. They must aggressively purchase peripheral bonds. That is the only solution other than allowing the system to implode and let the chips fall where they may.

Assuming that we continue in this state of limbo, we are likely to be stuck in a trading range. Another down day tomorrow would likely be a decent entry point for a long trade within our range. At the end of tomorrow we will no longer be overbought, short term sentiment has turned negative and we are getting stretched on the downside. Have a good night.

Dumb and Dumber

We have had nothing but bad news in recent weeks out of Europe, yet we are sitting within spitting distance of recent highs. The market clearly wants to go higher but the news out of Europe is making it nearly impossible. The market is looking for any signs of a clue out of Europe in order to take off.

Banks are being told delever in Europe. This means they have to sell assets, regardless of what measures governments are taking. It does not matter what budget Italy puts in place or what austerity measures it takes. Banks still need to sell assets. That is the reason sovereign spreads continue to blow out. There are simply no buyers for these assets (in the size necessary) other than the ECB. Everybody seems to realize this except for the ECB themselves and some German lawmakers.

The peripheral countries have agreed to the measures Germany and the ECB have asked for. It is time for the ECB to act. I apologize for the late posting but I don't know how many times I can repeat the same thing. There is simply nothing new to say. Hopefully, something will change soon but I'm not holding my breath.

Ignoring The News

Longtime readers of my blog may have noticed a difference in recent months. I used to rarely discuss the news or economic number of the day. I believe most of the time the news is just noise and it is better to focus on the various indicators I track.

In recent months I have done an about face and have spoken extensively about the situation in Europe. On days where the ECB decides not to buy peripheral bonds, spreads blow out and we go lower. When the ECB decides to intervene we go higher. While the indicators have worked well at the extremes, in between it has been all about Europe.

Many prefer a pure fundamental or a pure technical approach. There are dangers in mixing the approaches as confirmation bias comes into play. It is much harder to be objective when mixing approaches as if one does not find the data they are looking for in one approach they can look to the other.  I have kept this in the back of my mind at all times and try not to let this happen.

Wrote CVS puts

I wrote the January CVS 37 Puts naked.

Good Morning ECB

The ECB has finally stepped into the market today and peripheral yields have come back in although they are still wider on the day. As long as spreads hang in we have likely seen the bulk of the damage for the day.

The chart below from Bloomberg depicts today's roller coaster in Italian ten year yields.

Incomprehensible

The ECB only bought 635 million Euros of sovereign debt last week. That is far below the pace they have been buying at.  I find this action incomprehensible, given that EU countries are doing exactly what is being demanded of them. The ECB seems to be on a kamikaze mission to topple the Eurozone into a depression.

Europe, Europe, Europe

I believe that the market is poised to rally if we can get a reprieve  from the European woes. Sentiment is neutral, seasonality is positive and investors as a group are conservatively positioned. I don't believe we need to see a solution out of Europe for a rally, just some quiet for a little while.

Unfortunately, the EU summit brought more of the same. The Germans managed to squeeze more austerity and budgetary controls out of EU nations in return for more rescue plans that have no way of getting funded. The tricky part of analyzing these rescues is that the ECB has the power to aggressively intervene in bond markets. It was not unreasonable to believe that in return for further budgetary discipline, the ECB would intervene more aggressively. This is not the case as the ECB is allowing spreads to blow out again today. Further complicating the issue is the fact that every time we face the abyss they finally do intervene, but just enough to keep us in limbo.

In the short run we are overbought and will remain so through Wednesday. The overbought reading will likely put a lid on the upside in the early portion of this week. While the very short term might be challenging, I believe that the odds favor the bulls in the coming weeks. However, if the situation in the EU does not improve it will likely be a rally to sell into.

Momentum Funds

Hedge funds are having a terrible year. While they are loathe to admit it, most hedge funds run a momentum strategy. De-risking when things look bad and re-risking when things look good is a momentum strategy by another name. They like to call it risk management but it is momentum.

In many cases it is not the hedge funds fault as clients split at the first sign of any draw down. Taking a stand becomes a life or death gamble for a hedge fund. I know a few people that recently have started hedge funds. I have been told that nearly every prospective investor wants to know about risk management strategies. My risk management strategy is to buy cheap. That type of answer would not fly with most institutional investors. They want to hear about stop losses and other strategies that essentially turn a hedge fund into a glorified momentum fund.

I believe that a primary reason for the volatility we have been seeing is that there are so many momentum strategies out there. While the news flow has been volatile the moves get amplified by momentum strategies. This volatility offers excellent opportunities for value investors who use prices to their advantage or mean reversion traders who buy at points of pessimism and sell at optimism.

Tricky Juncture

The market is at a tricky juncture in the short term as I can make both bull and bear cases. The short term bear case primarily hinges on the fact that we will be overbought at the end of today, although it won't be a great reading. A lot of the remaining bears are likely being squeezed out today as they have been looking at this EU summit as a catalyst and it has failed. Nothing has really changed in Europe to merit optimism and Europe should continue to be a drag.

The bull case is that with the big, bad event out of the way we can finally enjoy the positive seasonality. The Santa Claus rally could be exacerbated by the fact that so many are under invested. The supply/demand equation greatly favors the bulls as corporations are aggressively repurchasing shares while the window for IPOs and secondaries closes towards the end of the year.

Withholding Judgement

The only good news coming out of Europe is that expectations were so low for any results that we are seeing a "buy the news" reaction. In the short run the extreme selling we saw yesterday and high level of pessimism towards a solution in the EU should buffer the downside. It is important to remember that the EU has come close to the abyss but has intervened before the Armageddon scenario was allowed to occur. Now that they have wrung out every concession they have been looking for from member states, it is even more unlikely they will allow the Armageddon scenario to occur.

Today's news was not inspiring, even with very low expectations. I will withhold judgement until next week when we get the full details of the plan and see how aggressive ECB actions are.

Vacation Over

The market has given me quite the welcome back. Thank you Ms. Market for at least allowing me to enjoy my vacation.  I believe that the late day swan dive has lowered expectations for tomorrow's EU summit to nothing. While we could see a little more downside, I believe the bulk of this move lower is over. Have a good night.

Not Again

We have seen a familiar pattern since early August of ~10% rallies followed by ~10% declines. This current move looks like the beginning of all the other 10% declines we have seen. If history repeats we will move lower in pretty much a straight line.

I don't believe the pattern will play out this time. I don't believe we have seen the same level of exuberance as previous times. There is an almost unanimously negative view heading into the EU summit that has kept sentiment from reaching an extreme. Additionally, there are only so many times people can panic in anticipation of a catastrophic event. While I could see another down day I believe the decline will be short lived.

Amgen Tender Period

Amgen outperformed greatly during its tender period, as the statistics said it should. Logic also dictates that a company that repurchases 10% of its shares in one fell swoop should perform well. Despite this no less than 3 analysts downgraded Amgen during the tender period. More remarkable, in addition to downgrades Amgen received other bad news during this period and still managed to outperform.

I sold my shares early but was able to profit off of the tender offer. I find it amazing what nonsense people trade off of, yet when there are situations like this where the odds clearly favor a trade they are largely ignored.

Clearheaded and Murky

I return from my vacation refreshed and clearheaded. Unfortunately, the short term market outlook is still a little murky. I believe the intermediate term outlook still favors the bulls, which is keeping me at a medium sized net long position.

In the short term we are becoming overbought. A rally into the weekend would make us overbought, although it would not be a great reading as we have chopped around for the past week. Sentiment has turned bullish but is not extreme. The EU has yet to put forward any viable solutions making us dependent on vague statements. The short term seems like a coin toss to me.

Looking a little further out, I believe the odds favor the bulls. The biggest positive the bulls have going for them is the continued strength in corporate profits which has led to share repurchases and cash M&A. As long as this continues it is difficult to imagine much downside. Large market participants such as hedge funds are under-invested. If they ever decide to return to more normal exposure levels there will be a lot of money coming into the market. Seasonality is especially positive this month and continues to be so in January.

I don't want to belittle the intermediate term risks. Europe is slowing down. Taxes will likely rise in the US just as fiscal stimulus is removed. However, these effects are unlikely to be felt for a couple of months and I will put greater weight on them as we move out in time or as market participants turn more bullish.

 

What Im Observing

This is what I'm observing today.

Capital Observer On Vacation

I am going on vacation and will return on Thursday, December 8. I am maintaining a medium sized net long position. Have a great weekend.

Ouch

My portfolio is actually down quite a bit today, even though I am long and the market is higher. Throughout the year the defensive nature of my holdings has helped me, but it is killing me today. Defensive stocks are underperforming while financials are going through the roof.

This market has been a consensus killer all year. The most hurtful thing this market could have done is rally the financials at the expense of everything else. While it is hurting me, I cannot help but admire how sneaky this market is.

Pullback Risk

Even though I see a decent risk of a pullback I am not looking to reduce my medium sized net long exposure. I am willing to sit through a pullback given the improving news out of the EU. I have sold out of too many good intermediate term positions looking for a short term pullback.

Day Five

Today is the fifth trading day of the rally. Longtime readers know that I believe it takes about ten trading days before a strong rally gets exhausted. That does not mean we will not have pullbacks along the way. I would not chase this rally if we have another big up day today, as I would be very surprised not to see a pullback or at least some consolidation early next week.

Sentiment has vastly improved from where it was a week ago. That said, we are not seeing giddiness yet. Market participants have been burned so bad recently chasing moves that I suspect they are distrustful. If we do see a pullback early next week followed by a rally later in the week I suspect we will see some giddiness right around the time the market gets overbought.

From a fundamental standpoint the news from Europe is improving. The ECB has been active in the sovereign debt market for three days in a row. The rescues being reported involve the ECB and aren't immediately being shot down.

Why I Bought BMC

I have been holding a position in CA Technologies for about a half a year. During this time I have become familiar with one of their competitors, BMC. When I was building my CA position, BMC traded at a roughly 30% valuation premium to CA, even though it only offered slightly better growth. Since then BMC has fallen by 30% and now only trades at a slight premium to CA.

Like CA, BMC has a mainframe business and some growth businesses in cloud and virtualization. BMC billed itself as a cloud computing company and attracted growth investors who are now fleeing after disappointing growth. BMC now trades at less than 7 times forward free cash flow (excluding net cash). That is a dirt cheap valuation and they are aggressively repurchasing shares.

BMC's CEO spoke at a conference on Tuesday. We are two months into the quarter and the CEO said growth is on track for the quarter. It is unlikely that we will get another disappointment in the near future. I started a position in BMC yesterday as the valuation is compelling. The cheap valuation combined with an aggressive share repurchase plan should keep the downside in the stock limited. I believe a conservative fair value for BMC is in the mid forties.

Giving The Rally A Chance

I was not very impressed with the announcement yesterday from central banks on dollar swaps. The coordinated move had a lot of bark but little bite. At current borrowing rates Italy is insolvent regardless of whether there is a dollar shortage or not.

The good news is that ECB has been defending peripheral yields since yesterday morning. Yields on the Italian ten year bond have fallen by over 50 bps since yesterday morning. We have seen the ECB defend peripheral yields before only to back down and let them soar. It will be very important for the ECB to keep this up.

While a consolidation might be in order there is no reason the current rally cannot continue. We will not be overbought for a while as the rally is only three days old and sentiment is still skeptical of a rally. This can turn out to be another rally to sell or the start of a bigger move. I believe the key will be the actions of the ECB. If the ECB continues to intervene and lower peripheral yields or a plan that includes the ECB is announced we should continue higher. If the ECB steps away and more plans with no funding are announced than this is likely just another rally to sell. I will give the bulls the benefit of the doubt until we are closer to an overbought reading.