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Taking A Bullish Stance at Trader’s Narrative




Taking A Bullish Stance


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The following is a guest post by a buy-side analyst working in a US asset management firm:

Except for short periods of relief, the last few months have been painful. After extensive deliberation on the question of equity market direction, I continue to be outright bullish. The core causes of the recent selloff are longer term in nature and I believe the climax of hand‐wringing is behind us. Accordingly, I believe the bottom for this correction has been made and the focus of the market will shift back to data on the cyclical recovery. And the most likely scenario is that the cyclical data will resume its previous strength as investors realize that final demand trends and corporate balance sheets are healthy. The scale to the right outlines the core bullish and bearish argument.

bullish bearish commentary Jul 2010

At the top of my list of bullish arguments is that cash yields zero and, perhaps more importantly, it will continue to yield zero for long, long time.

At the risk of over simplification, consider the following question: What better time to buy risky assets than when asset reflation is paramount to recovery and the central bank is intent upon encouraging risky behavior?
deflation reflation risk seeking Jul 2010

And consider that in 2009 net new purchases of bond funds reached an unprecedented $350 billion, 16 times the amount invested in bond funds in 2008. In contrast, net cash flows into stock funds totaled under $14 billion. So what happens as those bonds mature and as cash and money markets continue to yield a big donut? Do investors step out on the curve for a bit of yield? Not in any meaningful way. Do they move into corporates? If that hackneyed term, bubble, should be applied anywhere corporate bonds are the most deserving.

As investors are essentially forced to take on risk, I believe the most likely scenario is that flows accelerate into that detested and cursed asset class we call equities. Take on risk now willingly or be forced to buy in later at higher levels. It is time to focus on upside and the reward, rather than the penalty, for assuming equity risk.

As always, we must consider the question: what if we are wrong? This view is most likely wrong under 1,050 on the S&P, at which point I advocate doing something defensive in the portfolios. Specifically, raising cash levels 2-3% and reallocating one position toward defensives. Nonetheless, as I hope to have made clear, I like the risk reward at these levels.

Why the Equity Selloff?
The best answer to the above question appears to be that long term uncertainties are being expressed in current pricing. In other words, the market has shifted focus from shorter term cyclical data to longer term structural economic problems. At first glance that statement may not appear too profound, yet it has frightening implications given that fiscal balance sheets in Developed Markets (DM) are a bloody mess. Obviously, markets are forward looking, but the time horizon usually extends out two or three years. The market is now looking out beyond this horizon and seeing a world of incredible uncertainty. The idea is best expressed by the economists at JP Morgan who build the following logical sequence in trying to pinpoint “what went wrong” and why risk assets have sold off:

dispersion of earnings Jul 2010

Although tempting, one cannot simply assume the first conclusion is true, that the market is mispricing risk. Meaningful price moves must be respected. This leaves us with the original thesis that the market is looking toward the longer term. As additional evidence to the theory, they cite a record wide gap between short- and long-term implied equity volatility. With this shift in focus, the market is collectively asking all sorts of pesky little questions like how are DM governments going to stop and reverse the rise in their debt and what happens to growth if we all tighten fiscal policy at the same time (Is there a country not talking about fiscal tightening?) and how in the world do we bring down structural unemployment. It’s all about the long term right now and data and news on that front need to be the focus. Sustainable growth is the key, which will be signaled by private sector response to ultra loose monetary policy. Lastly, while this is perhaps obvious to most at this point, we must recognize that it is not about Greece per se, but that their problems are our problems and likewise, their solutions (or lack thereof) will be reflected in our markets.

The Positives

Here is the quick hit list of positives:

  • Monetary Policy:
    • In two short months all pressure to tighten monetary policy has vanished.
    • Central Bank Policy has shown a willingness to stay loose and encourage risk‐taking behavior
  • History tells us that the resiliency of the economy in a recovery usually wins these battles. A double‐dip recession is an extremely rare event.
  • Euro Banks (BEBANKS Index) have not broken down, in fact they have rallied off support:

Euro Banks index Jul 2010

  • Risk premium is a at a historical high and any moderation here would be positive:

slope of US market risk return tradeoff Jul 2010

  • Valuations are attractive:

earnings yield gap Jul 2010
Market Value attributed to flat earnings Jul 2010

  • Fading regulatory concerns (Global bank levy did not come to pass at the G20 summit)
  • No European apocalypse – while ugly in the periphery the core is still strong and getting better.
  • Economic Data out of Germany has been on a tear
  • Realization that this dip in the financial markets is not going to feed into the economy
  • Bottom‐up sell side analysts are not seeing slowdown in pipelines and channel checks (e.g. Rich Gardner)
  • Sentiment levels at or close to panic:

panic euphoria model CIRA Jul 2010

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5 Responses to “Taking A Bullish Stance”  

  1. 1 Tony

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    I’m turning bearish but I must say AWESOME POST!!!

  2. 2 william

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    interesting post. the only thing i would ask is: aren’t 2010 profit forecasts for the S&P 500 ahead of 2007’s S&P earnings? I’m not afraid of a double dip, but factoring in future earnings in many cases seems a little grandiose given the expectations of some analysts. Also, using such expectations, Hussman has a good post on his blog about decade trends for analyst expectations of forward earnings being too positive. The last thing is that I notice that Goldman Sachs Volume At Risk amount of the past quarter had been reduced dramatically, which makes me feel like if the smartest people in the room aren’t trading and making money, then what chance do I have? Good luck to all.

  3. 3 Robo

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    Great post on the Bullish Stance, but just maybe this is another almost perfect set-up to get folks long again.

    Could this be another set-up to get chartists and mo-mo players buying?

    Could this be a head-fake to get Bears to cover their short positions before the next sell-off? I think so, but you must decided that. I went short at the close today with no stops for now. Good trading to both the Bulls and Bears. Both are having a very tough summer. S&P 975 is now a coming in my opinion after getting several new buy signals today from the chart-slaves the last few days…..

    Thanks for a great site. It’s a daily read for me and one of the best out there….

    Good trading to all this summer….You will need it as programmed trading computers flip and flop the chart-slaves from buy and sell signals the rest of the summer on low volume.

    I’ll pass on the Bullish Stance for now, but will go long again when most of the chart-slaves are on sell signals again. It shouldn’t be long since one of the better ones I know flipped 3 times just last week.

    Yeah - I know, I could be wrong here, but that’s what make a market.
    I’m short for now!

  4. 4 Jay@MarketFolly

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    To play devil’s advocate, wasn’t this the exact same rationale behind the rally in the 2nd half of 2009 to begin with? As cash had nowhere to go, everyone took note of the massive bond fund inflows as people sought yield. Noting bond fund inflows as a reactive/contrarian indicator and making the case that equities were undervalued, tons of hedgies entered equities around June/July as evidenced by their commentary in investor letters at that time.

    So here we are exactly a year later, and the same thesis/rationale comes into play? Remember, just playing devil’s advocate here. Thoroughly enjoyed your post thought and hope to see further commentary in the future.

    Jay
    @marketfolly

  5. 5 Bo

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    It is meaningless for controversy over whether US economy is hit hard by double dip recession.

    1) If double dip recession really come ture , its damage is low due to widespread expectation.

    2) A slowdown in U.S. economic growth is imminent certainly.

    3) The most two important question is “ When can US economy enter a recovery stage again?” and ” how to change my trading strategy in this stage”

    By answering the first, I observe ECRI LED is at lower area in history and rebound is highly possible to come soon. Of course I cannot timely predict the corner.

    Secondly, when ECRI LED starts to turn up , US economy is likely to recover again. In expansionary satge, the positive return probability of stock is higher so I will rise my expsoure to long position.

    The follwoing report is useful to adjust trading stratery in 4 stage of economic cycle.

    At this moment, I am bullish on stock.

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