A Pause is Likely. Selloff? Naah!

Once again the market touched 1100 on the SP, hitting my year-end target (+/- 25 points). This has proved to be a very clear technical barrier which also represents a fairly valued market territory at roughly 15x forward earnings, especially given the early stage of economic recovery.

Contrary to many skeptics out there, I don’t expect a major selloff after hitting this target. A pause and consolidation are likely and would be a typical market reaction before we can overtake such a tough overhead resistance and move higher. I don’t expect the market to move much above 1125-1150 either, and as I have been saying for months now we are sort of in a 10%-15% trading range. The best strategy in this type of market is to buy aggressively oversold high beta stocks, with decent fundamentals, on pullbacks to bottom of the range and to sell calls or partial positions as we get near the upper boundaries, like we are now. Shorting indexes in this tape is just not a smart strategy, you will be better off shorting very overbought individual stocks to exploit the volatility.

I see the fear of underperformance and greed of money managers that have not been paid in over a year as a powerful combination to support the market in the final two months. The recent data should provide enough confidence that we ARE in the early stages of economic recovery. Even the housing is beginning to show signs of stabilization and improvement. The next leg up would likely be a reaction to a more robust economic improvement. We would need to see the topline-driven margin expansion, and sustainability of cost cutting efforts, as productivity remains a real engine of earnings growth. However, I continue to be highly mindful of any changes in sentiment, as the medium term expectations about the robustness of this recovery are getting a bit on a high side. Unless it continues to be balanced by the same degree of pessimism that provides a nice wall of worry for the market to climb, we may be setting ourselves up for some disappointment.

There is a real possibility that we might see negative returns in the first quarter of 2010, with some down drifting lasting through the end of February/early March 2010. This could be the last real opportunity to get in for yet another leg up in the market, as analysts start moving their forward estimates to 2011, making the valuations seem more attractive. Then watch for the likes of Roubini and Kass (and other vocal bearish prognosticators) to throw in a towel or become irrelevant, in the next few months. They will likely cause an army of ‘glass-half-empties’ to finally enter the market.

The main threat I see for a real selloff (not just a small dip as we have been seeing over the last few months) next year is the Fed. The Fed has been a non-risk factor thus far the investment process, but it will likely to change next year, as the unemployment stabilizes and the need to support the crashing US currency becomes a matter of national priority for politicians as they no longer debate the merits of nationalized healthcare. We are already seeing other Central Banks’ interventions to prop up the green back, but the Fed could do it easily if they chose to by just raising rates. And since no one right now believe that they will be raising rates anytime soon, this could potentially be a pretty nasty catalyst for a market selloff. I do hope that they will take their time and will slowly articulate the conditions that would necessitate the change in the interest rate policy, telegraphing their intentions well in advance.

So to summarize, I see opportunities on the long side for the rest of the year and remain firmly in the dip buyer camp. I see no real negative catalysts and completely disagree with those still clamoring for a substantial selloff. At the same time, I am not complacent and remain vigilant about managing my risk, especially as we get near critical technical levels as we are now. I continue to watch the US dollar and commodities for direction of the market on a daily basis, but see this more as a trading and tactical weapon. As long as the sentiment remains in check and Fed behaves the only place to be is equities. Additionally, the 25bps return on cash and the overcrowded bond trade is not likely to attract any real capital.