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Bears Got Trapped

6/22/2014 10:50:03 AM

Market Summary

The Market got what it wanted to hear from Federal Reserve Chairman Janet Yellen as she signaled stocks are due for more gains. Listening to Ms. Yellen speak is like getting lectured by your grandmother, but nonetheless she is following former chair Ben Bernanke's philosophy in that whatever is good for the stock market is good for America. Look, you can find 100 or 1,000 analysts who will proffer conflicting opinions on why the market should've or shouldn't have performed as it has since the recession started. But I don't care who you talk to, no knowledgeable market watcher can seriously deny that the Federal Reserve's various iterations of Quantitative Easing (QE) is the steroid that has juiced the stock market to stratospheric levels. We can talk about and debate innumerous theories on how to price stocks and what factors will influence whether shares will go up or down. However, at its most basic core, what drives the price of any investment is straight-forward, simple supply and demand. If there are more buyers (demand) than there are sellers (supply) the price has to go up and will continue to rise until there is equilibrium with demand equaling supply. Conversely, if there is more supply (sellers) than there are buyers (demand) the price will always drop until there is equilibrium. You can do quantitative analysis and apply all the advanced economic theory you want, but in the end it is the basic demand = supply equation that will drive the price. The reason all the 'expert' financial prognosticators keep getting it wrong about a market correction, crash, etc. is because they ignore that fact the Federal Reserve is supplying unlimited demand 'QE' to keep stock prices afloat. Company earnings, U.S. political system dysfunction, global political and economic unrest, chronically poor labor markets, etc., none of it have really mattered. Ben Bernanke started the free money train and Janet Yellen is committed to keeping it rolling, and until it comes to a complete stop, betting against this market is a very risky bet indeed.

Personally, I am in the camp with those who believe there should have been no stimulus programs and the Federal Reserve should not have bailed out the banks or implemented any of the QE programs. Where is the money and how has it helped the middle class? The Fed liquidity and the close to $1T in stimulus went to large corporations, financial institutions, and overseas (remember part of the stimulus was to give Brazil money to drill in US owned waters?). Banks got to borrow money for nothing and then sock it away in guaranteed returns. The Obama Administration initiatives and policies were geared to help the large multinational exporting companies and friends, not the small businesses who rely on the US economy and US wages for their prosperity, the businesses that create the majority of US jobs and create our wealth. The money never got to the middle class or unemployed as Bernanke claimed. Since 2009 the Fed has been very generous with its money. The Administration claims it has created millions of jobs and that the economy is headed in the right direction. The data does not support the claim that the money moved to those needing it! The empirical evidence of the status of the average US citizen shows it has not.

Even if the market closed the year at its current level it mark best three-year run for stock since 1997-1999 period.

Recent Weekly Update articles mentioned "The past few weeks 'risk on' categories have been the best performing sectors as small caps, energy and financials are leading the market higher." The updated performance graph below reflects the two major themes of the past few weeks. Oil and gas prices have gone higher as chaos in the Middle East and Ukraine brings into question whether the world-wide energy supply is at risk. The other theme relates to the discussion above about the Federal Reserve's continued easy money policy. Janet Yellen's comments indicate the Fed is not concerned about fighting inflation any time soon. Gold has surged the past few weeks as investors are buying it as the traditional inflation hedge. Conversely, higher inflation expectations are a negative for treasury bonds as prices have dropped in response to higher yields demanded by buyers.

Market Outlook

According to the Stock Traders' Almanac, in the mid-1980s the market began to evolve into a tech-driven market and control in summer shifted to the outlook for second quarter earnings of technology companies. NASDAQ's mid-year rally from the end of June through mid-July is strongest. The accompanying table shows NASDAQ averaging a 2.3% gain since 1985 during the 12-day period from June's third-to-last trading day through July's ninth trading day versus 0.4% for the month of July. Since the bursting of the tech bubble in 2000, NASDAQ's mid-year rally has a spotty track record with seven appearances in the past twelve years. However, it has been solid for four years straight including a whopping 7.5% advance last year.

The markets current bullish move is driving increased retail investor interest in equities. Retail investors have dropped $61 billion into U.S.-based stock funds this year, according to Lipper Analytical Services. Tom Bradley, president of retail distribution at TD Ameritrade Holding Corp, told the Reuters Global Wealth Management Summit on Wednesday that retail clients have an average of 19 percent of their assets in cash, slightly below the historical average of 20 to 25 percent. Advisers working with the firm are even more bullish - with 8 percent of their clients' assets in cash. "We still think we are in one of the biggest bull markets of our careers," said Rich Bernstein, founder of Richard Bernstein Advisors LLC in New York, and a former top Merrill Lynch investment strategist.

According to Bloomberg News, bearish bets against the S&P 500 index have risen to levels not seen since 2012. Plus, bearish wagers against the Nasdaq 100 index ETF (QQQ) have jumped above the 12-month average. The trend over the past few years has been for shorts to get 'squeezed' whenever they get antsy and start shorting the market. One reason shorts are now licking their chops is the smallest 500 stocks in the Russell 3000 have dropped almost 15% since the beginning of March, according to Pension Partners. The smallest 1000 have shed 8%. We expect maybe a slight market pullback over the next few weeks, but ultimately, short sellers will end up chasing stocks higher, especially as earnings season progresses. Recently we said "That upward momentum is waning with downward price pressure to relieve overbought conditions." The updated Heikin-Ashi chart below shows how the market set up a 'bear trap' to squeeze short sellers, especially after investors responded favorably to this week's Fed announcement the bears had to chase prices to record highs.

The CBOE Volatility index (VIX) closed at its lowest in more than seven years on Wednesday. To some, this suggests investors have become "complacent," that is, ignoring potential problems that could derail a rally, but a number of strategists suggested that just because investors aren't paying for protection does not mean they don't have worries. "You always want to be on guard for excesses ... but as it stands now the bias does appear to be toward the upside," said Dan Greenhaus, chief strategist at BTIG, who sees the S&P 500 at 1980 by year-end. As we said before "Notice in the updated chart below how as the S&P 500 index has moved higher during the current bull market the VIX has trended toward all-time lows."

Last week we said "From a contrarian perspective, retail investor sentiment is becoming excessively optimistic. It is generally assumed most retail investors are wrong about market direction, therefore contrarians are betting on a near term market top to relieve the overly bullish reading." Retail investors have backed off significantly from the extremely bullish reading from a week ago. As you can see in the updated results below, the current bullish percent is actually lower than average, but investors are still not bearish as the higher than normal neutral reading indicates general indecisiveness about market direction.

Previous analysis of National Association of Active Investment Managers (NAAIM) exposure index said "Professional money managers have gotten on board with the current bullish trend as their latest index is higher than last quarter's NAAIM 84.40% average reading. Another factor contributing to money managers' putting more funds to work is the need to rebalance their portfolios for the second quarter window dressing due at the end of the month..." Money managers' current exposure is 88.59% and you can expect a high reading as rebalancing continues.

Trading Strategy

We recently opined "Gold prices appear to have bottomed out a support line that has been in place since the beginning of the year. Now is probably an opportune time to look at setting up trades that will profit if gold does bounce off its support level. Gold appears to be bouncing off a support level that has held up the price all year. Your bullish trades to take advantage of the bounce off support should already be profitable with gains continuing to run." The current gold rush has probably made most of its move and now is the time to takes some profits and/or tightens stops to lock in gains. If the price stalls out at resistance, a price neutral gold trade is probably a low-risk opportunity.

As you can see in the chart below, gold and treasury bonds continue to maintain an inversely correlated relationship. Depending on how your investment portfolio is set up, gold and treasury bonds can be used to hedge against each other and the equity market. For example if you took our suggestion to bet on higher gold prices a few weeks ago you should be showing a nice profit. Long bullish gold trades are now more risky since the price has surged and shorting gold is also a risky move at this point. But a long bullish Treasury bond trade is inexpensive and low-risk right now, and if/when gold drops you can expect bond prices to then move higher. Also, you can expect bond prices to rise if equity prices drop significantly.


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