Looking Out

I decided to remove my hedges today, a bit earlier than I was planning to. The market remains overbought albeit less so than a few days ago. We are also heading into the first few days of the month, which are generally strong. I have been putting a bigger emphasis on my longer term view recently rather than my shorter term view and it has largely paid off. Have a good night.

 

Removed Some Hedges

I removed some hedges and am now at a medium sized net long position. I respect the possibility of a further correction but am trying to focus on the bigger picture, which is more benign.

Two Indicators That Are Not Pointing To A Major Peak

While there are plenty of indicators pointing to some froth in the market, both the NAAIM survey and the Investors Intelligence survey are not at levels consistent with a major peak in the market. At previous peaks the NAAIM survey approached 90% bullishness while it currently sits at 56.33%. Below is a graph of the NAAIM survey. From the NAAIM:



The Investors Intelligence bears generally fall to roughly 20% at major market peaks. The Investors Intelligence bears now sit at 28.7%. At the last two major peaks they got as low as 16%.

There are plenty of imbalances in world economies so its possible that we see a systemic event. Barring a systemic event its unlikely that we are seeing a sentiment induced major top. That does not mean we cannot correct.

Less Certain

Whereas I was pretty certain we would see a correction a few days ago, I am less certain where we go from here now that the market has gone down three days in a row. The bulls can argue that the market has done the minimum on the downside. There have been a flurry of cash M&A deals announced recently which should help digest the overbought reading as well. The bears will argue that the market is now intermediate term overbought and that sentiment is still on the bubbly side even though it has calmed a bit.

I still expect the overbought reading to contain the upside but would not be surprised if we have already seen the price low for this correction. Corrections are about time and the market can correct by going sideways or going lower. The bears still have time on their side so it's possible they can still do damage.

While there is the risk of a further correction I want to remind readers why I think it's a mistake to get too bearish. Corporations continue to repurchase shares at a near record pace and engage in cash M&A.  Valuations are reasonable and we are still in the sweet spot (November to April) of the year in terms of seasonality.

I would likely turn more positive as this overbought reading is worked off, whether it is worked off by going sideways or lower. I started to reduce my hedges yesterday and will look to further reduce them as time passes or prices correct.

Quick Update : Part II

I am slowly starting to remove some hedges in the pre-market. I expect more of a correction but will be removing hedges gradually. Capital Observer will return tomorrow.

Quick Update

This is a quick update. Capital Observer will resume Tuesday.

I believe we are in  a period of correction as we will be intermediate term overbought at the end of the day on Monday. In my experience time is more important than price in measuring a correction. Sometimes the market can correct by going sideways for a few weeks while other times the market plunges over those same few weeks. I am planning on remaining cautious until some time passes and/or we get a correction in price.

I don't expect the market to collapse completely but a correction of 5% from the recent highs would not surprise me nor would some chopiness for a few weeks.We are approaching the turn of the month so its possible the market tries to rally but I don't believe it will make much progress. If the market manages to score a new high during the turn of the month period I would likely further reduce my moderate net long exposure.

Traveling

I will be traveling today but have an open order to increase my hedges at around current levels. I expect it to be filled.

Sharp Onlooker

A reader, Onlooker From Troy, pointed out in the comment section that Rydex traders flipped uber bullish yesterday. This extreme flip flopping is unusual. The Rydex indicators are now bearish for the market.

Value Wins In The End

When I was building my position in CA Technologies I overwhelmingly heard bad things about the company from analysts and investors. These were the most common criticisms:

  • They are a slow growth company. There are so many companies out there with better growth.

  • The stock has gone nowhere in a decade.

  • The management team is not the best (to put it lightly)

  • Management will squander the money

  • A highly paid hedge fund consultant said CA is where good technology goes to die.


When I looked at CA I saw a company that was trading at less than seven times free cash flow (FCF/EV) or a greater than 14% cash yield. If the company is able to consistently generate so much cash despite the fact that they don't have good management than the underlying business must be really great. Where a stock has traded in the past decade matters little to me. If we were able to simply extrapolate the past into the future we would all be rich. Management had already committed to return 40%-50% of free cash flow to investors so at most they could squander half the money. A 7% cash return was still not bad.

The mistake most made in their analysis of CA is that they completely ignored valuation. There is no price at which they would have liked this stock. I would love it if CA grew like Salesforce.com but the free cash flow yield on Salesforce.com is a fraction of CA's. Salesforce.com would need to increase their free cash flow many times over before they yielded as much as CA. I prefer a bird in the hand.

I have been holding CA for over a half a year, all the while hearing about what a terrible stock it was. It was not  a pleasant experience but as a value investor and a contrarian I am used to it. After earnings last night CA broke out to a multi year high. CA has solidly outperformed nearly every large cap software stock during the period I have owned it and the market as a whole. Value wins out in the long run and for CA the long run has finally arrived.

 

One More Push

There is a lot of put buying once again today in the early going. I believe this argues for one more move higher to shake out all the new found bears. For clarification, I am not playing for this move higher as I believe we are too close to a correction to get cute. I might use the push higher to reduce my net long exposure if we get it.

A Change Of Heart

We saw a stark change in the attitudes of market participants yesterday as the crowd seemingly turned cautious. Leveraged Rydex traders flipped from bullish to bearish in a single day. I cannot recall such a swift move to bearishness from these traders. The put/call ratio at both the ISE and CBOE showed heavy put buying as well.

As readers know I have been looking for a correction. I would have preferred if the market had actually gone down first before market participants turned cautious. While there are certainly enough signs pointing to the need for a correction it is possible that the market stages one more rally before the correction starts. A rally later this week would occur just in time for the market to become intermediate term overbought. It would also likely vanquish the new found doubts of market participants.

 

Out For The Day

I will be out for the rest of the day but have orders in to reduce my net long positioning upon further strength.

The Trickiest Thing

The trickiest thing the market could do this week is go sideways. Than the bulls could argue we have worked off some of the excess by going sideways. We worked off the last overbought reading by going sideways as well. While the bulls would have a point the reason it would be difficult for me to accept this time is that we will now be intermediate term overbought and there is more excess bullishness than the last time.

Identifying A Top

Bottoms are much easier for me to identify than tops. At bottoms the doom and gloom is thick and the fear and panic is in the air. All one has to do is close their eyes, buy and hold on. It also helps that many of the sentiment indicators work better at bottoms. Extreme optimism has the potential to last longer than extreme pessimism.

Just because it is more difficult to identify a top than a bottom it does not mean that trying to identify a top is a fruitless endeavor. The more signs of a top that are present, the less favorable the risk/reward is in the market. Unfortunately most prefer to deal in binary outcomes rather than probabilistic outcomes. Most people don't want to hear that the risk/reward proposition of owning stocks  is declining. They just want to know if the market is going to go up or down.

The way I see it the risk/reward proposition of buying stocks now is low. While I could see the current rally lasting another week, there are enough signs of a top present such that it would not surprise me to see a correction start this week. Tactically, I have been using strength to reduce my net long position and will use further strength to continue doing so.

The Hard Money

The easy money has already been made as we have gone from extreme pessimism to extreme optimism. During this period the S&P 500 has gone up over 20%. It is possible that sentiment stays extreme and we grind out a few more percent before a correction. But chances are that when this correction arrives these gains are taken away.

All this does not mean that there is no more money to be made, only that there will likely be better opportunities. If we did get some sort of a correction, the risk/reward would look a lot better. My best guess is that the market struggles in the days after expiration and a bigger correction should start by late January.

When Will This Rally End

If this rally somehow manages to last through next week we will be intermediate term overbought and I could just imagine that sentiment would be gaga, given how frothy it already is. It would be a magnificent short term risk/reward short if it happens.  I am seeing numerous signs of froth today that might mean the rally will not last that long:

  • I have heard "dont fight the tape" more times today than I have in nearly a year. This is not something you hear at a bottom.

  • The CBOE total put/call ratio and equity are at extreme levels not seen in nearly a  year as well.

  • There is almost no discussion of macro issues anymore.

  • The top callers have given up. Even though sentiment has been bullish for a while now many have been looking for  a short term correction. I am no longer seeing that anymore. Or at least those looking for a pullback are not willing to bet on it.

Waiting For Expiration

My sense is that any upside from current levels will be retraced once we finally do get a correction, as sentiment is getting a bit frothy and we are overbought. The days after option expiration tend to be weak so I would not be surprised to see a correction early next week.

I want to take a step back and look at the intermediate term picture, making a list of both the positives and negatives:

The Positives

  • At Thanksgiving large investors were "de-risked". While sentiment has vastly improved it is unlikely that large investors have had enough time to position themselves aggressively as they tend to move slowly.

  • Retail investors are largely out of the market. All one has to do is look at the results of any of the online brokers. If they decide to come back they will be a new source of demand.

  • The Investors Intelligence survey still has about 30% bears. Intermediate term tops tend to occur when this number is closer to 20%

  • Seasonality is positive for the next few months. Seasonality has worked wonderfully for the past two years.

  • Corporations are repurchasing shares aggressively and there is a good deal of cash M&A.

  •  Valuations are reasonable as long as earnings come in anywhere near estimates.


The Negatives

  • Almost every sentiment survey and the anecdotal evidence I am seeing is showing excess bullishness. This is not generally a positive for forward returns.

  • The market is overbought on a short term basis and in about a week and a half will be overbought on an intermediate term basis.

  • The European economy is slowing and it is beginning to effect earnings.

  • A year ago the payroll tax deduction came into effect, which helped year over year comps for all of 2011 versus 2010. Starting now, this will no longer be a benefit.

  • Much of the stimulus from 2008 is rolling off and will soon be  a drag on comps.

  • The numerous imbalances and excess debt are still present. This has the potential to flare up at any point.

My Weakness

I slightly added to my hedges at the close. I am very slowly looking to reduce exposure. I generally turn bearish too early so I am working very hard not to do so. My trading is better at the extremes. Right now we are getting close to extreme bullishness but are not quite there yet. Have a good night.

Groucho Capital Observer

I have slightly added to my hedges and will use further strength to reduce exposure. I remain in a medium sized net long position but am hoping to be able to reduce it. I have been bullish for months while the crowd was looking for the end of the world. Like Groucho Marx I don't want to be part of a club that would have me and the bull side is starting to feel crowded.

Hedge Fund Geniuses

I am hearing that hedge funds are broadly up 3% for the year. That is impressive given that they don't run anywhere close to 100% long. I am also hearing that they have all turned bullish. The returns are likely the result of a self fulfilling cycle. Hedge funds tend to cluster into the same stocks and when they turn bullish they buy more of those same stocks, improving the performance of their portfolio and the broader group.


There are undoubtedly many highly paid hedgies patting themselves on the back, feeling like the geniuses that they always knew they were. Last year was a fluke. Until the cycle turns down again ofcourse. Don't get me wrong. There are undoubtedly geniuses in the hedge fund world but for every real genius there are at least a dozen others who think they are.

Banks Quietly Raising Equity

This week Morgan Stanley announced that bonuses will be maxed out at $125,000 in cash while the rest will be paid in stock. Many financial companies are now paying the majority of bonuses in stock. This amounts to a stealth equity issuance in the tens of billions of dollars.

Going into earnings most employees are locked up and cannot sell stock. Some time after earnings, usually 3 days, the lock up ends and employees can sell stock. Imagine that you were an employee at Morgan Stanley  that was paid largely in stock. Your salary is dependent on Morgan Stanley and now so are your savings. The logical thing to do is diversify by selling Morgan Stanley stock as soon as possible.

As financials report earnings, lockups will be ending for employees with billions of dollars of stock. This will be a headwind to the financial sector in the next few week and is something to consider before buying financials.

Growing Confused

There are too many signs out there that there is excess bullishness. The sentiment and newsletter surveys all have bulls on the high side. Rydex traders are aggressively positioned and we have seen a decent amount of call buying in recent weeks. Anecdotally, I have been hearing that hedge funds have turned bullish as well.

Despite all this evidence I cannot shake the feeling large investors are not positioned aggressively. They were at very low levels of exposure in early December so even if they are bullish its unlikely that they have ramped up their positions to aggressive levels. We are in a seasonally strong period and corporations are aggressively repurchasing shares.  Additionally, the trading does not seem very exuberant to me.

There is too much evidence out there for me to ignore that bullishness might be getting out of hand. I am officially downgrading my market outlook to confused.

No Excitement

The best trades happen when market participants get over excited in one direction or another. It has happened numerous times in the past few weeks that it appeared investors were about to get over excited but have not. This morning was one of those occasions.

We were looking at a big gap up this morning and I was getting ready to make some sales. As we reached closer to the open the gains fizzled and we have sold off since and I have not made a trade. This lack of emotion is the opposite of what we saw for the past few months and makes short term timing a bit trickier for me.

All Bulled Up

I noticed a big change in the tone of market participants over the past 24 hours. It seems that the crowd is now all bulled up because we did not go down on the S&P downgrade. The crowd has seemingly forgotten that they have been looking for a correction. This does not mean that we will necessarily head lower, but it does mean that the risks have increased.

The S&P 500 has rallied over 20% from the November low. While the change in sentiment is unlikely to mark the exact top, it likely signifies that we are in the later innings of this rally. Tops are very tricky as they tend to be processes and can last for months.

There are a few major factors that are in the bulls favor. This rally started with investors at low exposure levels. It will likely take a while to reverse this positioning, meaning that the bullishness has the potential to persist. Seasonality is favorable for the next few months. Cash M&A and share repurchases continue at a steady pace.

I am not planning to make major changes to my positioning. I will be looking to use these higher prices to gradually add to hedges. The decline in the VIX makes protection reasonably priced.

Downgrade Done

The widely feared downgrade of Europe happened and we are still here. European bond markets barely blinked but the stock market used it as an excuse to correct its overbought condition. The downgrade rumors that go around every few days are now a thing of the past. Have a great weekend.

Traded Up

I sold my Oracle position to make room for the additional Vodafone I bought today.

Very Tempted To Buy the Euro

There is an old Wall Street adage "sell on the rumor, buy on the news". These European downgrade rumors have been circulating for months. Buying stocks on this news is tricky because the market is overbought. Stocks may be looking for an excuse to correct. The same cannot be said for the Euro. The Euro has gone down relentlessly. I cannot help but think this might be a good spot to buy the Euro for a trade.

Reasons Why An S&P Downgrade Is Good

I think that today's S&P downgrade of Europe is a non event. Everybody knew it was coming. That said, the market is stretched so it might use it as an excuse to correct. I believe that the S&P downgrade may even turn out to be a positive for the following reasons:

  • The news will soon be behind us.

  • The persistent downgrade rumors will end.

  • Now that only Germany is AAA, the EFSF can officially be put to rest. It is now even more painfully obvious that the ECB will need to participate in any rescue. The illusion that a rescue could be done without the ECB is harmful.

Added To Vodafone

I have added to my position in Vodafone. Morgan Stanley reduced 2013 estimates on weakness in Europe from 163 pence to 162 pence. The stock trades with an 8% dividend yield and 10% free cash flow yield. I could not care less about a penny here or there, or a pence for that matter. I believe this is an opportunity. Vodafone is my largest position.

The Correction

It appears that S&P is set to downgrade numerous European countries. The market is stretched so its possible that we see some sort of a correction. I believe that it could be bought, eventually.

No Giddiness

The market is in a tough spot as it is hard to buy because we have risen so much, but is also hard to sell because sentiment refuses to get exuberant. Every time the market goes up, market participants start looking for a pullback. This leads to very shallow pullbacks followed by a  a grinding rally higher.

We are likely to only see shallow pullbacks until market participants get exuberant. I thought we were on the cusp of it this morning but instead of jumping on board the crowd faded the strength. All that did was refuel the bull. The correction will come when people stop looking for it.

What's Next For CA Technologies

Reading between the lines in the letter from Taconic Capital to CA management, Taconic is requesting the following:

  1. They want CA to aggressively repurchase shares(optimize capital structure)

  2. Stop doing acquisitions(increase profit margins)

  3. Change the management compensation structure to align with the first two goals.


CA is either going to implement these changes or we are likely to see more action from Taconic, such as requesting board seats. I believe these changes are precisely what need to be done. If this is properly executed CA shares should rise above $30.

Repurchased Oracle

I have repurchased a portion of my Oracle position.

The Grinding Rally

The market is slowly grinding higher as underinvested managers use every dip to buy but are reluctant to chase the market higher. The market will be overbought at the end of the day today but it won't be a great reading. If we see some giddiness by the end of the day it would likely be a decent spot to make some sales.

I see many traders that have been unsuccessfully looking for a pullback as short term sentiment has gotten a bit heady. It has happened too often to me that I have been bullish intermediate term yet found myself net short because I was looking for a small pullback. It was just not worth it. About a year ago I decided that I would no longer allow myself to get into that position. As the market gets more frothy in the short term I will make sales. But I will not find myself net short until I am intermediate term bearish.

 

An Oldie But A Goodie

In light of the news of an activist investor at CA, I wanted to bring back an oldie but a goodie. This is me telling the CEO of CA to bite the bullet at the CA Investors Day in July.

Halleluyah

I have written extensively about the cheapness of CA Technologies and the benefits an activist shareholder could bring. Today, Taconic Advisors filed an activist position in CA. They own just over 5% of the shares. They are speaking to management and asking management to repurchase shares and improve margins. This is precisely what I believe needs to be done.

Gilead / Pharmasset Deal Closing

The Gilead takeover of Pharmasset will likely close tomorrow. This is an $11 billion cash deal. Deal closings are positive for the market as some of the money is put to work in other stocks. According to Trim Tabs 1/3 of the value of a  deal are felt as a market inflow upon closing. Using that formula, the Pharmasset deal closing should pump over $3 billion into the market. Have a good night.

Morning Thoughts


  • Sentiment and the market are a bit stretched . The best outcome would be if we got a pullback to alleviate this condition. I believe it would be buyable.

  • If the best thing the market could do is correct a bit, does that mean the market will continue to frustrate and grind higher?

  • Investors Intelligence bulls are getting high at 51%. But bears are also high at 30%.

  • Large cap pharma is starting to look a bit expensive. Did everybody forget about the patent cliff?

  • European stocks should outperform US stocks in the long run. That valuation divide is huge.

Opposing Forces

We have opposing forces of overcooked short term sentiment and underinvested money managers. If we continue to grind higher I will slowly sell into a rally. If we get a scare I would likely use the dip to reload. Have a good night.

The Whole Picture

When I look at the bigger picture I see an underinvested investment community. However, when I look at today's action I am starting to see some extreme short term sentiment. Call buying has been extreme today. This is the first day of hand over fist bullishness I can recall since the rally began.

My bigger picture view has me holding on to my core medium sized net long position. My short term view has me cutting back on trading longs and non core positions.

Large Investors Underinvested

I have been arguing for weeks that large investors are underinvested. A Bloomberg story this morning backs my suspicion:
Rallying stocks have done little to entice professional money managers back to U.S. equities.

A gauge of hedge-fund bullishness measuring the proportion of bets that shares will rise climbed to 44.5 last week from 43.9 at the end of 2011, holding close to the lowest level since 2009, according to International Strategy & Investment Group. Compared with the price of the Standard & Poor’s 500 Index, managers’ so-called net exposure is close to the lowest since June 2008, the ISI data show.

I believe that today's action is largely underinvested managers jumping back in the pool. If hedge funds are as underinvested as this article implies it will take a lot more than one day before they are fully invested.

 

Sold Oracle

I have sold the balance of my Oracle position. Using higher prices to slightly cut back on longs.

Making It Hard

Had the market rallied hard anytime before today it would have been an easy decision to fade the strength for a short term trade as we were overbought. However, the worst of the overbought reading wears off at the close today. The market alleviated its overbought reading by going sideways for a week.

Pinpointing the next overbought reading is difficult because the market has been choppy. If we rallied through Thursday we would be overbought, but it would not be a great reading. Pinpointing a selling point will be tricky and I will need to rely more heavily on when we start seeing giddy sentiment.

I am not looking to go short but simply looking for points to reduce my long exposure. After big washouts like we saw this Summer and Fall it takes a lot longer to form a top as market participants have low levels of exposure. Even after the 20% rally from the lows I suspect large market participants are not anywhere near fully invested.

Random Thoughts

Its difficult to come up with full length posts when the market has not budged in a week. Instead I will go with some random thoughts:

  • The worst of the overbought reading should be worked off by tomorrow's close. That would not make us oversold. It likely would make us neutral to slightly overbought.

  • This would be the first time in over a half a year that an overbought reading did not do a lot of damage.

  • I think that a whack coincident with us working off the overbought reading is likely buyable.

  • The tougher call would be if we rallied into tomorrows close.

  • Jefferies came out negative on the software sector today due to a tough 2012. No matter that they were bullish 30% higher. Did they think there would never be a slowdown?

  • In the long run valuation is the only predictive factor of stock prices, yet most analysts completely ignore it.

  • What do readers believe the current state of market sentiment is? Are we seeing too much/extreme optimism?

Geniuses

I rarely watch CNBC but turned it on in order to try and get a better sense of the sentiment out there. Unfortunately, I could not bear to watch long enough to come to a conclusion. I find it amazing how these guests know everything about everything. They can get asked a question about a financial stock, than a tech stock, than an oil stock and then on the European economy and they have  a definitive opinion on everything. Is there anything these people don't know?

Too Much Company In The Bull Camp

Sentiment indicators that are pointing to too much bullishness are starting to creep up. Rydex traders have been in the overly bullish camp during the most recent rally, but on Friday they moved towards the extreme bullish camp. Earlier in the week we saw individual investor bears shrink to extreme levels as well. Anecdotally, I am not seeing that much bullishness but the numbers don't lie and I believe there is something to it.

I remain of the belief that the large investors such as hedge funds are positioned relatively conservatively. This makes the likelihood of a large decline absent a systemic event small. However, the overly bullish sentiment from traders and small investors is increasing the probability of a short term decline.

I have used the recent strength to cut back on my aggressive trading positions but have kept a core medium sized net long position in tact. I would likely use another leg up to cut back even further as I am growing concerned about the possibility of a short term correction.

The Art of Sentiment

I am a strong proponent of using sentiment as a trading tool. The theory behind using sentiment as a trading tool can be summarized as follows: When the crowd is extremely bearish it is likely they have already sold, leaving fewer sellers and creating a low risk buying opportunity. The opposite occurs when the crowd is extremely bullish. Its likely they have already bought and there are few buyers to propel the market higher.

Right now a few of the sentiment indicators I look at are showing bullishness being on the high side. However, most evidence points to large investors being positioned very conservatively. The Merrill Lynch Fund Manager survey as well as the ISI Hedge Fund surveys show equity exposures being  on the low side. Anecdotally, it seems few in the hedge fund world are very bullish.

In essence sentiment indicators are a tool to help figure out how the crowd is positioned. Looking at all the evidence it seems that large investors are still positioned conservatively albeit less conservatively than they were a few months ago. Shorter term traders seem to be more bullish. This leads me to believe that there is risk of a pullback but the risk of a large drop is low, barring a systemic event.

Many are pointing to the sentiment indicators as proof of a coming collapse. A year ago sentiment indicators became far more extreme than they are now and stayed that way for a long period of time. The reason that was able to occur was that investors "derisked" in the  Summer of 2010 and decided to "rerisk". If large investors decide to "rerisk" again this year we could see a repeat.

Mixed Feelings Remain

I know I am starting to sound like a broken record  but my short term outlook continues to be mixed. The good news is that the bulls have managed to hold the market steady despite the overbought reading. That is something we have not seen in a long time. If they can limit the damage for a few more days the worst of the overbought reading will be worked off. Have a good night.

Trimmed Oracle

I trimmed my Oracle position. I am keeping the balance as a longer term position.

Fund Managers Still Bearish

I have been arguing that despite the sentiment surveys starting to show too many bulls that large investors are positioned conservatively. The latest Merill Lynch Fund Manager survey seems to corroborate my belief with over 1/3 of managers overweight cash. From Reuters:
The monthly global fund managers' survey from Bank of America-Merrill Lynch showed a net 35 percent of fund managers were overweight cash, down from 38 percent in November but still a high reading. The index reading shows the difference between overweight and underweight positions.

"It's pretty grim. We end the year with investors holding lots of cash, expecting low growth and being quite risk averse," said Gary Baker, European equity strategist at BofA Merrill.

"Two thirds of respondents are describing 2012 to be below trend growth."

What Makes Us Overbought

Looking at the chart below of the 10 day moving average of the NYSE Advance-Decline line it is easy to see that we are overbought:

However, the reason we are maximum overbought is not because of the chart above. After all, every rally stops at different levels of overbought. Some at higher levels and some at lower. The reason we are overbought is because of the raw data that goes into this 10 day moving average. Below are the numbers being dropped from the 10 day moving average over the next 10 days:

For the next 4 days we will be dropping large positive numbers. The numbers replacing them are likely to be lower making it likely that we are now at the maximum overbought point. The trick for the bulls will be to get past the next 4 days without too much damage. After that the numbers become more mixed.

For over a half a year every overbought reading has led to a large decline. This does not necessarily need to be the case. Overbought readings can be worked off by going sideways or correcting by a small amount.

In the sentiment arena we have gotten some troubling numbers overnight. The AAII bears dropped to the lowest level in years. Additionally, Rydex traders are at their largest net long exposure since this rally started. This adds to recent data that shows the Investors Intelligence bulls at 50%, which is on the high side but not extreme. Additionally, the put/call ratios are overbought.

Anecdotally, I am not seeing that much bullishness and believe large investors are positioned conservatively. I don't believe this overbought reading will lead to a large decline. But I will heed the numbers and try to refrain from adding back trading longs until we are closer to having worked off this overbought reading. I am keeping my medium sized core net long position in tact.

 

Bulls Emboldened

The turnaround today will likely embolden the bulls to make some more upside tries this week. Unfortunately, the market is overbought so I don't believe they will be able to make much headway. My near term outlook remains mixed as I don't expect a large move in either direction. Have a good night.

Don't Ignore Valuation

The biggest mistake that fundamental investors make is to ignore valuation. When the news flow is positive no price is too high for a stock and when the news flow is negative no price is too low. I take a more balanced approach and try to put both good news and bad news into perspective and analyze if it is already priced in.

A stock price is supposed to take into account the prospects of a business many years into the future. However, an unjustifiably large portion of a stock price is dependent on the outlook for the current quarter or year. Over the coming decade there will likely be at least 2 recessions and at least 2 expansions. One needs to remember when the news is good that there will be recessions. One must also remember when the near term outlook is bleak that there will be expansions.

A great example of this short term thinking is investors attitude towards Oracle. Six months ago investors were happy to pay $36 for Oracle. Today they hate it at $25. What really changed? Growth slowed a bit because of the economy, as it has at many technology companies. Earnings estimates for the coming year were lowered by 4%. Oracle still trades at less than nine times these estimates net of cash. A few months ago investors were willing to pay nearly 50% more for this business.

I have little doubt that over the long run Oracle should outperform the S&P 500 as it trades at  a hefty valuation discount.  I would much rather pay a low price for a company when the news is bad than pay a high price when the news is good.

Raising Long Exposure Slightly

After reducing long exposure yesterday, I slightly increased it today by writing covered puts against some of my hedges.

Conflicting Thoughts

I have conflicting thoughts as to the near term direction of the market. The market has some issues such as the overbought reading on both the NYSE advance-decline line and the put/call ratios. On the positive side it seems that there is little belief in this rally and that the pain trade is higher.

The average hedge fund was down between 4% and 9% last year depending on which index one looks at. In contrast, the total return on the S&P 500 was +2%. Most managers came into the New Year positioned defensively. The large rally yesterday put them behind the market to start the year and the pain trade is higher. Few were excited about the markets rise yesterday and that is a good thing.

As a result of my mixed feelings I have pared back my shorter term trades but am sticking with a medium sized core portfolio. Given these mixed signals I expect a decline to be contained barring a severe worsening of the crisis in Europe.

First The Bad News

The bad news is that the market is just about overbought. The good news is that nobody believes in this rally. The S&P 500 is up 70 points in the space of two weeks, yet the crowd is still skeptical of the rally. The best risk/reward trades occur when both the sentiment and overbought/oversold indicators line up. Right now we are getting conflicting signals. Have a good night.

 

Not Too Bad

While the market is overbought and could see a pullback, I don't believe there is cause for too much concern. We are not seeing the type of exuberance that would worry me and we are in a benign period of the year. Barring a significant worsening of the crisis in Europe I think that a pullback will be contained to a few percent. While I scaled back the majority of my trading longs, I am sticking with medium sized core long exposure.

Reducing Longs

I have reduced my trading longs from last week.

Late In the Rally

By some measures the market will be maximum overbought at the end of the day today and by other measures the market will be maximum overbought at the end of the day tomorrow. Regardless of which indicator we look at (10 day moving average of advance-decline line or 10 day moving averages of the put/call ratios), we are approaching a short term overbought reading. The seasonal strength in the market should last through tomorrow but then weakens. It seems that a lot of evidence is piling up that we are getting late in this rally from a short term perspective.

The last few times we have gotten short term overbought, the market has completely fallen apart. The bulls would like to see the market hold itself together while working off this overbought reading. From an intermediate term perspective the rally still has room to go. Sentiment is not yet extreme and we are not intermediate term overbought.

A rally through tomorrow would likely lead to some short term weakness. As we get short term overbought I will look to pare back trading longs and possibly write covered calls.