Start Throwing Longs Overboard

It's been a long time. I have no excuses. Now on with it :-).

The consensus everywhere that this market has to go up because of QE2 (quantitative easing) by the Fed is starting to chip away at my better reasoning. QE2 makes perfect sense to anyone from a mechanics perspective, of course. The more dollars are in circulation, the less each dollar is worth, and therefore, the more it costs to buy virtually anything, including stocks. And if the Fed gets what they really seem to want (getting inflation higher than the real risk-free interest rate--the rate on a short-term CD, for example), then all the money in CDs, money market accounts, and other "risk free" instruments will come out of those instruments and chase "risk-on" returns with higher returns.

Everyone is cheering on the market while the retail investor remains distrustful and is hanging onto the greater portion of their cash. As a result, the inflows to this market are being almost solely controlled by people who understand and are interested in economics and hear about what the Fed is doing all the time. Therefore, the concentration of people trading this Fed effect of showering the market with free money is very high compared to what it would be historically. This is likely a Wall Street and not a Main Street rally, to sound cliche.

Shorter term (next month or so, at least), by what I have seen over the past two days, I think you'd be a bit crazy to be just leaving lots of long positions out there and riding the wave up. In fact, I sold Brookfield Asset Management (BAM) and Intersil Corp (ISIL) this morning for 6% and 13% gains respectively, and I have an order in to sell Warner Chilcott (WCRX) tomorrow morning for what appears to now be a 15% gain. Why am I lightening up in the midst of the euphoria? Well, a good reason to lighten up happens whenever you start getting euphoric, and as you can see, I've got some pretty good gains on the table now. Whenever I start to smile at the sight of my daily positions, it's time for me to start dumping. But let's look at evidence I'm seeing in the charts.

The daily chart of the Wilshire 5,000 ($WLSH) is starting to throw off some compelling, but not yet fully baked arguments. The Relative Strength Index (RSI) is above the overbought threshold of 70. I'm not seeing divergence yet (see prior blogs) which is when I usually start dumping stuff, but given the run-up we've seen, I'd like to lighten up going into this. Another week or two of this type of action, and we will get divergence on the RSI, and then those gains all go away. Again, I'm lightening up a bit here and there, not all at once. Look at the stochastics as well. The way stochastics tend to work is that you want them to diverge once, dip below the overbought line, diverge again, and then dip below the overbought line once more. Look at how the stochastics have not kept pace with the price line, but not only that--they have already dipped below once, and are levelling off in the face of some very steep price increases. So the momentum indicators are starting to deaden, and pulling off a few positions as the days go by would be prudent.

Now let's take a look at a completely different animal, the VXX ETF, which tracks the short-term futures of the volatility index for the S&P 500. Look at how the index drops steeply beginning last week after having already taken quite a ride downward since the short European debt scare. Now I want to draw your attention to the volume bars over the past couple of weeks, and particularly yesterday (10/11). Yesterday had quite a price decline, relatively speaking, on the highest volume day in 3 months. What does this mean? Well the price on this index tracks the amount of "insurance" traders and investors are buying on their positions out there. You buy insurance when you think bad things might happen or when you have a just-in-case attitude. You can even look at how fast the decline in the Accumulation/Distribution line has accelerated to see that everyone is firmly buying into the Fed as the market's savior and that basically nothing bad can happen. People are throwing their insurance overboard faster than I've seen in a very long time.

Now what does that mean? Logically, everyone barely has a safety net out there to protect from downside losses. Now consider that the S&P is only marginally positive for the year (5%), and put yourself in the shoes of a money manager who is nearing year-end. If you see a couple of sharp sequential daily declines before January 1st, which happens in most quarters at some point or another, these money managers will dump all of their positions just to ensure that they stay positive for the year. Now I'm not saying this will happen for sure, but the way things are going, the odds are good. I don't think anyone anticipates we'll continue now until 2011 as hot as we have been recently. Markets just don't go up that way.

Now let's look at economics. We're going into the Christmas season. Money is free out there, but Americans are delevering, and for now (as long as it lasts) their appetite for debt is minimal. So it's really hard to entice folks to spend beyond their means--something governments really shouldn't do but this country has been doing since the Ford administration. Of course, I probably don't have to mention that with tax and social policy in the balance, employers will have not much to look forward to in hiring folks. The rate of increase in price of soft commodities (food, textiles, and other stuff we buy at Target) is getting rather concerning at this point. So people are likely not going to have the most optimistic outlook on the home front this Christmas.

Earnings season is here, and those earnings look very good. That's a great thing, but the market looks forward. So let's fast forward to the end of the season for the major financials when Goldman Sachs reports on Tuesday of next week. Let's assume things continue to go the way they are (i.e., good) because there's no reason to think they won't. We get through a good swath or earnings, and then we realize that the whole season will be good. OK, once we fully realize something, it's yesterday's news, and we'll have gone up probably a good 13-15 handles on the S&P at that point. Now what? The Fed said they are going to shower the economy with free money. It's not like they can announce another quantitative easing right away. The American public is already digesting the fact that they are printing away the value of much of our long-term savings. There's only so much we'll swallow. Emerging markets are being very vigilant about keeping their growth in check (doing a masterful job, I must say). And finally, there is that fear that companies really do start spending that money on their balance sheets, which they will at some point. That's right, I said fear. 6 months ago, I was hoping for it. Now, with the Fed's attitude and interest rates at zero, corporate spending could push us into quite an inflationary spiral.

Maybe I'm biased because I hate government intervention, in general. I agree that what the Fed is doing is constructive for asset prices right now. After all, that's the whole point of it. But if I told you that I would make a country great by taking savings away from people through devaluing what they already have and lending more of it back to them at zero interest so they'll feel better about themselves, would you vote for me?

As usual, thanks so much for reading!

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