Sage Weekly Letter – 3/4/2012

There is a strong tendency among financial market participants to project the recent past into the future and position themselves accordingly. For example, in early October 2011 few were optimistic and positioned to benefit from a rally in risk assets. In fact, at The Big Picture conference on October 11th 99% of the attendees were either neutral or bearish on the market and no one had anything positive to say about Europe. In hindsight that was a powerful indication of what was to come over the ensuing months as markets made a series of higher lows and higher highs as risk appetite climbed the macro wall of worry higher into the new year.

After a five month risk rally which has seen the $SPX rise 300 points, the Russell 2000 ($IWM) rally nearly 40%, and large cap tech ($AAPL, $MSFT, $QQQ) post absolutely stunning 30%+ gains in less than 3 months most market participants are bullish and projecting the recent gains into the future through their positioning (notice the sub 10% cash allocations) and sentiment. While sentiment isn’t ultra-frothy and long exposure isn’t ultra-aggressive (leveraged long) it is still worth noting that the same people who were recommending heavy cash and/or short exposure at SPX 1075 on October 4th are now positioned bullish and calling for SPX 1450+ in 2012.

Remember the end of stock picking, the risk conveyor belt, and the era of 80%+ correlations among equities? Just when these phrases were being used on a daily basis and valuation metrics used in fundamental analysis (P/E, PEG ratios, etc.) were being tossed out the window it was the time to be a contrarian and focus on stock picking. It has been a “stock picker’s market” since October 4th, it’s just that most market observers didn’t notice until recently:

Notice the significant outperformance of $FCX and $IWM from late November through early February – this has now turned the other way as small caps and various market “leaders” such as FCX have taken a notable turn south recently.

So now the conventional meme is that macro analysis has taken a back seat and stock picking is the name of the game these days – Naturally this should make an astute market observer, not necessarily a contrarian though, sit up and think things over more deeply. While the macro wall of worry has still been present during the 2012 rally, it has become much less daunting – The China hard landing/eurozone debt crisis fears of late 2011 have been temporarily replaced with Iran/Israel tensions and rising oil prices ($BNO $CL_F $USO). Central bank easing/liquidity infusions have provided strong tailwinds to the bull run and underinvested money managers who were caught flat footed entering 2012 have trampled over one another to buy each and every dip.

We know what has happened to help us reach this point but where do we go from here?  I’m going to go out on a limb and predict that equities will pause during March, however, I do not believe that there will be a significant correction i.e. decline of larger than 3%. The ECB just completed its LTRO2 last week and will likely hold off on further easing for at least a couple of months. In addition, the Federal Reserve is also likely to remain on hold at the next FOMC meeting on March 13th. This sets the stage for a period of 1-2 months in which markets will temporarily trade without central bank training wheels fully visible, a temporary void of sorts. Moreover, the macro wall of worry is likely to reemerge in the form of French presidential elections, deteriorating eurozone economic data, and Iran/Israel tenions that aren’t likely to fade away anytime soon (check out Bruce Krasting’s excellent thoughts on the timeline at play for Israel).

In summary, I anticipate elevated volatility within a relatively tight range over the next month – We will see a few 1%+ down days for the $SPX, however, I believe that the SPX 1338 area will be bought aggressively as underperforming PMs use the dip to increase equity exposure. While it is not the time to be adding to risk exposure, those who decide to “short in the hole” and/or sell into pullbacks will likely be punished with further underperformance.

Technical Picture

Tuesday after the market close I posted the following chart of the $IWM to StockTwits:

Click to enlarge (notes on the charts)

On Wednesday IWM broke the diamond to the downside and Friday the 81 support level was breached on a closing basis:

I also couldn’t help but notice that everyone and their brother made mention of the poor performance of the Russell 2000 on Friday (after it had already fallen more than 3% from its highs earlier in the week), this leads me to believe that the small cap correction is closer to the end than its beginning.

Large cap tech ($AAPL $MSFT $QQQ) has clearly been the market leader but after nine consecutive weeks of gains and huge gains of 25%+ from the Thanksgiving low one has to question the prudence of allocating fresh capital to this sector after such a run:

Should technology pause/pullback new leadership will need to emerge, which sector will it be?

Last Wednesday’s carnage in precious metals ($GC_F $GLD $SLV $SI_F) may have been the markets way of signalling an early warning that the central bank liquidity party may be taking an intermission:

A sharp $70 sell-off in 5 minutes on Wednesday morning – gold printed a bearish engulfing candle on heavy volume last week:

As is typically the case the sell-off in metals coincided with multi-month highs in speculative futures traders’ long interest:

While I don’t often look for chart patterns in economic indexes, I found it interesting that the Citigroup Economic Surprise Index for the United States has formed a head & shoulders topping formation and appears to be rolling down the right shoulder:

Many will interpret this post as being fairly bearish on equities overall, however, once again I repeat for emphasis that I don’t expect SPX 1338 ($ES_F ~1334) to be breached anytime soon:

I expect that the bulls will vigorously defend the red line above in the event that equities correct over the coming days/weeks.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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