6/4/2010 - All Indications Point to Higher Equity Prices through Summer

6/4/2010 - All Indications Point to Higher Equity Prices through Summer

Written By: Matthew Xiarhos
Categorized in: NEWSLETTERS

Equity Market Overview

As I wrote last Friday in a special bulletin, the potential upside in equities is significant. By all measures, public and advisory sentiment have recently exhibited some of the most extreme readings that have historically coincided with significant market lows.

AAII reported an astonishing surge in bearishness (fear/concern) to over 50% with bulls (optimists) dropping to 30% last week. That extreme one-sided view and the ratio of the bulls vs. bears has coincided with previous market bottoms.

Lipper FMI (formerly AMG Data Services) reported the largest weekly net outflow from equity mutual funds in their twenty year history! The public bailed out in a massive way. This is a capitulation in public sentiment of historic proportions. Because the outflow sets a twenty year record, it suggests that the emotional pain of 2000-2002 and 2008 is not only in the forefront of the public's collective psychology but also that most investors fear that the markets could devolve into a bear market of equal or greater magnitude. The public is more fearful now that at any time during these two massive bear market declines. That's huge. This is EXACTLY the magnitude and pervasiveness of fear and anxiety that corresponds with major market bottoms.

Hulbert's sentiment index tracks the equity exposure recommendations of newsletter writers. Recommendations can vary from 100% invested to 100% short (to profit from a decline). Like public sentiment measures, newsletter writers as a group, tend to be most heavily invested right near market tops and most defensive (or short) at market bottoms. The exact opposite behavior required to be profitable. Recently, newsletter writers have recommended that readers adopt the highest shorting exposure (to profit from a decline) in a very long time. They are as fearful of a further decline as the public is... What is important to note is that these recommendations are coming now AFTER a 15% decline! To add insult to injury, newsletter writers also recommended that their reader adopt the greatest exposure to the stock market right at the April top. In other words, they told their readers to own as much stock as possible at the top (the worst possible advice) and now they are recommending that readers short the market to profit from a decline! This summer rally will show them to be equally as wrong with that advice as they were at the April top.

In mid-May the S&P 500 and other major indexes declined below their psychologically important 200 day moving averages (which many technicians use to determine long-term trends). There have been two rallies back to this moving average. The first attempt in late May failed and led to a sharp sell-off and subsequent re-test of the recent late-May bottom. Over the last few days, a second rally attempt brought us right up to the moving average again. This morning the market opened lower by about 2%. It appears, for the near-term, that we might be turned away from this "all important" moving average again.

This process of rallying to a key resistance area (like the 200 day moving average) isn't uncommon as key psychological levels are recurrently tested. However, a successful rally above the 200 day moving average is a prerequisite to bring in buying and momentum to the market. In the off chance that equities cannot hold their May lows, I would be forced to reconsider my bullish outlook. However, the strength of the market internals and extreme market sentiment strongly weigh in favor of a market rally for several months. I believe that this near-term volatility will ultimately be resolved to the upside. Once the 200 day moving averaged is exceeded a great many analysts will again adopt a more optimistic outlook and bring buying momentum into the market.

US Equity Markets (Equity Style Model)

With respect to equity-style trends, the Small-Cap segments continues to out-perform. The "growth" segment of the small and mid-cap stocks have taken the lead. Leadership by this higher risk area suggests potent equity market upside in the coming months; though International markets are expected to out-perform.

International Equity Regions

International equities have fared quite poorly since the US Dollar's renewed strength. In fact, some European country indexes had dropped far below their February lows and most Euro countries continue to struggle.

However, Asian, LatAm and Emerging Market countries are poised for excellent upside in the coming months.

Investment Grade Bonds

We are long domestic investment grade bonds. The potential for a reversal in prices exists as investors reallocate to riskier assets in the coming months. Additionally, any lengthy decline in the US Dollar is likely to lead to a switch to international bonds.

High Yield Bonds

High Yield Bonds are highly correlated to equity prices but with less volatility. I expect they will do well in the coming months as the equity market rallies.

Real Assets / Inflation Hedges

Nearly all Real Assets are in defined downtrends. The only exception has been Gold which has held up well as a safe haven for the Euro region crisis. However, even Gold is looking toppy. REITs (Real Estate Investment Trusts) are our only long position in this asset class given our expectation for higher equity prices.

Currencies

Last week I noted that the US Dollar rally had become overdone and I had the expectation that the Euro would rally. While bullish sentiment towards the Euro is at a historic low and suggests a significant bottom I was too early and so far remain wrong on that call unless the Euro can firm up.

If you have any questions about our research or Absolute Return Portfolios do not hesitate to call. We can be reached toll-free at 877-632-7491.

Absolute Return Portfolio Management LLC provides absolute return oriented portfolio management and institutional research on global macro trends including equity style rotation, global regional equity trends, short-selling and market neutral strategies as well as fixed income strategies. Contact us for information on account minimums and institutional research offerings.

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Matthew N. Xiarhos, Founder & Chief Investment Officer

Absolute Return Portfolio Management LLC