Investors Now Embrace the Most Hated Stock Rally Ever – Is it Time to Bet on Short ETFs?

After a 12% rally investors are starting to buy into the S&P 500 and other indexes again. At the same time technical resistance is getting stiffer and seasonality is turning bearish. Is it time to buck the trend and start nibbling on short/inverse ETFs?

PIMCO’s king of bond funds, Bill Gross, joined the “stocks are dead’ club in late July and CNBC calls the latest rise in stocks the “most hated stock rally in history.”

At the June 4 low (1,267 for the S&P 500) investors and investment advisors hated stocks like fish hate hooks. Despite (actually because of) this negativity stocks keep on keeping on and June 4th turned out to be the second best buying opportunity of the year (see charts below).

But nothing is as persuasive as rising prices, and 12% into the rally investors are starting to embrace the idea of continually rising stocks. The crowd is generally late to the party (thus the term “dumb money”) and this time may be no different.

Investor sentiment is an incredibly potent contrarian indicator. Unfortunately, sentiment-based signals in recent months have been murky, but are starting to make sense again.

Murky Doesn’t Have to be Bad

Murky is not always bad though. The following is what I mean by murky during this summer and how the sentiment picture is starting to clear up.

The Profit Radar Report (PRR) continually monitors various investor sentiment measures, which includes the Investors Intelligence (II) and American Association for Individual Investors (AAII) polls as well as the Equity Put/Call Ratio and VIX.

The Sentiment Picture below was published by the PRR on July 20, 2012. Quite frankly it was one of the oddest sentiment constellations I’ve ever seen. The VIX was near a 60-month low parallel to a multi-month pessimistic reading of the AAII poll.

This just didn’t make sense and the simple conclusion was that there is no high probability trading opportunity.

Six weeks and several head fakes later the S&P 500 Index (SPY) is trading a measly 30 points higher than it did on July 20, and even in hindsight we know that there was no high probability trade.

Current Sentiment Picture

The second chart reflects the change of sentiment of investment advisors (II) and retail investors (AAII) since July 20. There’s no excessive bullishness, but rising prices are starting to resonate with investors.

Sentiment alone doesn’t tell us how high stocks may rally or if they are ready to crack right now. When we expand our horizon to include seasonality and technicals we see that September (especially starting after Labor Day) sports a bearish seasonal bias and that there’s strong resistance at S&P 1,425 – 1,440.

There is little reason for investors to own stocks right now. Aggressive investors may choose to pick up some short or even leveraged short ETFs at higher prices.

The Short S&P 500 ProShares (SH) and UltraShort S&P 500 ProShares (SDS) are two inverse ETF options that increase in value when the S&P slumps.

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With Stocks at Multi-Year Highs – QE3 May Be Overkill

The Federal Reserve is the most powerful financial institution in the world. It manipulates the world’s stock market seemingly at will, yet there are reasons to conclude QE3 is farther away than many expect.

Skunks are best known for their ability to spray a liquid with a strong, foul odor. The smell, a combination likened to rotten eggs, garlic, and burnt rubber, can be detected by the human nose up to a mile downwind. Smell aside, the spray can cause irritation and even temporary blindness.

The skunks reputation is well known, that’s why it roams around by day in the open and fears neither dog nor man. Skunks rarely ever have to use their “weapon” since just the threat of getting sprayed keeps predators at a safe distance.

The Fed, a unique financial animal, possesses a similar defense mechanism – it’s called QE .Like skunks, the Fed has established a reputation to use it when needed. This keeps “enemies” – such as market pessimists, realists, and particularly short sellers – at a safe distance. The Federal Reserve doesn’t necessarliy have to spray QE to get the effect of QE, just the threat is often enough.

Why Change a Winning Strategy?

Ben Bernanke is well aware of this fact. Essentially since the end of QE2 (June 2011), which resulted in a 20% stock market meltdown, Bernanke has been telling investors that the “Fed is ready to spray more QE when needed.” That’s been more than enough to keep stocks from collapsing. In fact, just the threat of spraying QE3 has lifted the S&P 500 Index (SPY) to a 51-month high and the Nasdaq-100 (QQQ) to a 12 1/2 year high.

Another animal analogy comes to mind. As long as you keep the carrot dangling the rabbit keeps running.

Why would Bernanke change a winning strategy (that of bluffing to spray or dangling the carrot) if stocks are already trading near multi-year highs? What, the economy is bad you say? The Fed’s past actions tell us that the economy may not be Bernanke’s primary concern. It seems easier to downplay millions of Americans being out of work than big losses of financial institutions on Wall Street.

QE Side Effects

Fortunately for the free market, there’s one asset class that keeps Bernanke and his inkjets honest. Oil. QE is inflationary. Like water in the bathtub that buoys rubber duckies along with all other toys, QE inflates the price of all assets (aside from those that have an inverse relationship).

Higher stock, gold, and silver prices are good for investors, but higher oil prices suffucate the economy. Oil around $110 a barrel coincided with stock market tops in April 2011 and March 2012. Oil at $85 in Apirl 2012 was enough to contribute to a 17% decline in the S&P 500.

With crude oil already trading near $100 a barrel, QE3 now or in the near future could be a double-edge sword with little net benefit for stocks and the economy (see chart below).

More About Skunks and QE

Skunks are reluctant to use their weapon, as they carry just enough of the chemical for five or six uses. The Fed has sprayed outright QE twice since 2008. This doesn’t include covert maneuvers like Operation Twist, currency swaps or low interest rates. How many more sprays of QE-like substances is the Federal Reserve good for? It seems to be running out of bullets.

Ironically, skunks have poor vision. This makes it harder for the stinky little mammal to decide who and when to spray. Bernanke’s “eye sight” (ability to foresee side effects of his actions) is similarly poor (click here for Bernanke’s bloopers). The Federal Reserve failed to see the 2008 financial debacle, or what’s been dubbed the “perfect storm,” brewing and has been playing catch up ever since.

An ounce of prevention is worth more than a pound of cure, but that’s a tough concept to grasp for a blind financial “animal” with a potent weapon.

 

 
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Apple Bullies the Nasdaq and S&P 500 But May Soon Disappoint Investors

The S&P 500, Nasdaq-100 and Technology Select Sector SPDR ETF are rallying to new multi-year recovery highs spurred by Apple’s record setting performance. As Apple goes, so goes the market, so what’s next for Apple?

Monday, August 20, 2012 is the day when Apple became the most valuable publicly traded company ever. That day the stock closed at $665.15 a share, giving it a market capitalization of $623.52 billion.

The previous record was set by Microsoft in 1999 when it was valued at $616.34 billion.

Apple is most certainly the biggest fish in the pond. How big? Apple accounts for 4.73% of the S&P 500 Index tracked by the SPDR S&P 500 ETF (SPY). The closest second is Exxon Mobil with a weighting of 3.22%.

All by itself, Apple’s share price matters almost as much as that of IBM, Microsoft and General Electric combined. While Apple dominates the S&P 500, it outright bullies the Nasdaq-100.

At $665 a share Apple controls 19.65% of the Nasdaq-100 and the ETF that tracks this index, the PowerShares QQQ (QQQ). Even more lopsided is AAPL’s share in the Technology Sector SPDR ETF (XLK), where it accounts for 20%.

Apple is so big that when Apple sneezes the U.S. stock market gets a cold. So how is Apple’s health?

Fundamental Analysis – New iPhone, New iPad … New Highs?

Consumers and investors are highly anticipating the new iPhone 5, the new iPad mini and Apple TV. With the holiday season coming up there are plenty of reasons to expect new all-time highs and record valuations for AAPL.

Apple trades at only 13 times earnings and many analysts consider Apple stock cheap.

Technical Analysis – Strong Resistance in Sight

The chart below shows AAPL on a log scale since 2000. I have shown the chart before, most recently in the July 22 Profit Radar Report, which stated that: “The upper red resistance channel will be around 660 later this week. A final push to kiss this trend line good bye would provide a beautiful technical picture and a solid sell signal.”

On Tuesday, August 21, the upper trend line resistance is at 679. Shares weren’t quite able to touch the line, which allows for new highs in the coming days.

If Apple shares follow the path of seasonal patterns in election years, we should see a top in Apple in late August followed by another seasonal high in November/December.

 

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The Dow Jones – Close to a Once-in-a-Lifetime Signal?

The Dow Jones sports perhaps the most unique constellation of our generation. Constellations don’t make money, buy or sell signals do. The Dow’s constellation may double as a signal and is of importance for investors.

Since the year 2000 we’ve seen the tail end of a technology boom without parallel, the lost decade, the biggest decline and recession since the Great Depression, record monetary intervention and the strongest rally since the Great Depression.

Bulls and Bears can probably agree that we live in unique times. A look at a long-term chart (with long-term I mean going back all the way to 1896) of the Dow Jones Industrial Average (DJIA – corresponding ETF: Dow Diamonds: DIA) shows just how unique.

The chart below shows the Dow Jones in a monthly log scale. Here are the most salient points:

·      There are two long-term trend channels (dotted grey lines). One stretches from 1903 as far as 1954. The other one starts in 1937 and is still active today.

·      The 50 and 200-month moving average (blue and red line) are on track to cross each other for the first time since the Great Depression.

I find the Dow’s interaction with its trend channel very intriguing. The 1903 – 1954 channel offered support and resistance at no less than seven major turning points.

Most notable is sequence of trend line interaction that occurred following the bust of the 1929 bubble. The Dow sliced back below the upper channel line and continued tumbling below the lower channel line.

This led to a strong rally that once again tested the upper channel line (red arrow). The same thing is happening now. The strong post 2009 rally has lifted the Dow high enough to test trend channel resistance.

In fact, the Dow has been flirting with this upper channel line off and on since late 2010, but hasn’t been able to stay above it for long. Channel resistance is currently around 13,200.

What does this unique constellation mean for investors? Since we are looking at a multi-decade trend line, we can’t use it as a short-term investment tool or signal.

Long-term investors should closely watch the Dow 13,200 range. Based on the 1938 analogy, the likely current is a counter trend and long-term investors should use current prices to unload equities and nibble on short positions.

Financials – Is the Most Despised U.S. Sector Getting Ready to Rally?

Investors are shunning the financial sector. Although financials account for more than 14% of the S&P 500 (SPY), investors (by one measure) have only 2% of their money invested in financials. Some contrarians take this as a buy signal, is it?

Knight Capital, MF Global, LIBOR fixing scandal, JP Morgan losses, excessive Wall Street bonuses … there seem to be unlimited reasons to dislike the financial sector (Financial Select Sector SPDR ETF – XLF).

When it comes to financials, investors are not only talking the talk, they are walking the walk. Right now financials are the most despised sector in the United States. Of the $900 million invested in Rydex sector funds, only $18 million are allocated to financials, that’s just 2%.

However, the financial sector accounts for 14.21% of the S&P 500 Index (SPY), which makes it the second biggest sector of the S&P (behind technology).

Extreme pessimism often results in unexpected price spikes. Is the financial sector getting ready to rally?

The Technical Take on Financials

Financials appear to be at an important short-term juncture, but let’s provide some long-term context before looking at the short-term.

From the 2009 low to the 2011 high, the financial sector (XLF) jumped from $5.88 to $17.20. Before that, XLF dropped from 38.15 to 5.88. Today XLF trades 61% below its all time high price tag of 38.15. In comparison, the Dow Jones Industrial Average (DJIA) is less than 8% away from its all-time high.

Important short-term resistance for XLF last week was at 14.85. This resistance was made up of the July 3 and 27 highs and a trend line that connects the March 27 and May 1 highs.

On August 8, XLF was able to close above 14.85. Such a break out is generally bullish. However, the volume on which XLF broke out was significantly lower than average (see chart below).

Based purely on the chart and sentiment, the bullish message deserves the benefit of the doubt as long as XLF remains above 14.80. But a break below 14.80 would severely ding the immediate up side potential for XLF.

What about the down side risk? Aggressive investors may decide to sell or go short XLF with a break below 14.80. The initial down side target would be around 14.45 – 14.50.

Using Asset Class Correlations to Predict Stock Market Moves

Every day about a billion shares of stocks exchange hands on the New York Stock Exchange , but stocks are not the only asset class on the planet. Currencies and bonds are part of the same financial eco system, and we shouldn’t ignore their effect on stocks.

There’s a Bavarian saying that encourages people to “look beyond the edge of their own plate.” Translated in investment terms this means to expand your horizon and look at more than just one asset class.

Several times over the last couple of months the S&P 500  (SPY) has been declared “dead”. In fact, a recent CNBC headline said that: “Bill Gross is latest to join ‘stocks are dead’ club.”

The Fed could have jolted the S&P back to life with a dose of QE3, but decided not to. Against all odds, rather than rolling over, stocks have sprung back to life – a case of “dead man walking.”

On July 25, with the S&P trading as low as 1,331, a special Profit Radar Report outlined why stocks are not ready to decline just yet.

The key to this bold forecast was found in the correlation between various asset classes. Below are excerpts from the special July 25 Profit Radar Report.

July 25, Special Report: Asset Class Correlations

Some asset classes boom while others bust and vice versa. For example, bond prices typically rise when stock prices fall. Those types of asset class correlations should be taken into consideration for any market forecast.

Individual outlook for long-term Treasuries: Long-term T’s are butting up against long-term resistance while relative strength (RSI) is lacking price. This suggests that long-term Treasuries are in the process of topping out. Falling Treasury prices typically means rising stock prices.

Individual outlook for the euro: The euro has been trending down since March 2008 and is currently trading just above the June 2010 low. Although euro prices dropped below the June 1, 2012 low, RSI is solidly above the June 1 low. This suggests that the euro is trying to find a bottom that lasts for more than just a few days. Any bounce could gather steam if the euro is able to move above resistance. A strengthening euro is usually good for stocks.

What this means for stocks: If the euro rallies and long-term Treasuries decline, stocks should move higher or at least have a hard time declining.

The chart below shows how the iShares Barclays 20+ Treasury Bond ETF  (TLT) and Currency Euro Trust (FXE) perform during times when the S&P is in an extended up or down trend.

With Treasuries near a top and the euro near a bottom, stocks should rally or at the very least have a hard time declining.

Sentiment Picture – Stocks are Not Ripe for a Prolonged Decline

Sentiment readings have sent conflicting messages. The VIX is near danger levels for the S&P 500 while the AAII crowd is almost record bearish (which is bullish for stocks). Here’s the current sentiment picture and what to make of it.

Investor sentiment is closely related to money flow and therefore an important indicator. How is sentiment related to money/cash flow overall liquidity?

Investor sentiment tells us how investors feel about stocks. If they are bullish, we assume that they own stocks. If bullishness reaches an extreme, we know there’s not much more cash left for buying.

If investors are bearish we assume they are sitting on a mountain of cash. The cash will go to work eventually and drive stocks up.

There are different ways to measure investor sentiment.

The CBOE Volatility Index (VIX) uses S&P 500 index options and projects the market’s expectation of 30-day volatility. Readings around 16 or below are indicative of investor complacency and tend to result in an up tick of volatility and lower stock prices.

The Equity Put/Call Ratio represents a proportion between all put and call options purchased on any given day. A low put/call ratio means that investors are buying more calls than puts. This is a reflection of bullish sentiment; therefore readings around 0.6 tend to coincide with market tops.

A high put/call ratio means that investors are buying more puts than calls. This is indicative of fear. Readings of 0.9 tend to occur at the end of down trends.

The sentiment survey conducted by the American Association for Individual Investors (AAII) reflects how individual investors feel about stocks: bullish, bearish or neutral.

Investors Intelligence (II) polls investment advisors and newsletter writers. Their opinions are categorized as bullish, bearish and correction.

There are other sentiment and cash flow measures, but those four offer a balanced few of sentiment.

The Profit Radar Report always monitors sentiment and publishes a detailed sentiment report at least once a month. The chart below was published (available to subscribers only) on July 20, 2012.

The VIX was trading below 16 (bearish for stocks) while AAII investors were extremely bearish (bullish for stocks). II investment advisors on the other hand were becoming more bullish as the AAII crowd turned bearish.

Unfortunately, sentiment did not provide a clear signal then (it still doesn’t), but it showed a) that stocks may not be able to decline for good and b) that there was no high probability trade set up. This prevented investors from making trades they might regret afterwards. Based purely on sentiment, choppy market action may continue.

 

What A Difference Would QE3 Have Made?

“No QE3 for you” the Federal Reserve said on Wednesday. The market showed it’s disappointment. What a difference would QE3 have made?

“Central bank interventions are like sausages. They taste better if you don’t know what’s in them.” – Some German guy who writes a Newsletter.

The Federal Reserve and European Central Bank have cooked up a smorgasbord of ‘financial sausages’ since the 2007 bust. Stuffed in appealing high performance casings, the Fed was able to sell all kinds of smelly sub-par trimmings (QE1, QE2, etc.) as prime beef.

Few people cared because stocks were up and the sausages looked good. After a few cases of financial food poisoning however, people are starting to wonder what the Fed and ECB have been mixing in their QE sausages.

Still, for some “odd” reason Wall Street is begging for more of the same. This week the Fed played hardball and didn’t allow more than a sniff of the next sausage. That’ll have to do for now.

No Accountability to a Higher Authority

The chart below emulates the label central banks have been putting on their faulty products. The slogan is something like this: “Financial sausage consumption increases wealth.” At first glance, who could argue? QE1 resulted in higher stock prices, so did QE2 and LTRO I + II. The Dow Jones Industrial Average (DIA) trades only 9% lower today than 58 months ago at its all-time high.

But the DJIA is not the only measure that matters. People can’t eat DJIA, and the kind of indicators that measure prosperity (or lack thereof) of average American’s look pretty dismal.

Below is the one chart that shows what QE can and cannot do and who QE does and doesn’t benefit (hint: Wall Street bankers still get to celebrate their bonuses at Ruth’s Chris).

2007 vs. 2012

The Dow Jones today is only 9% below it’s 2007 peak reading.

Unemployment is about 85% higher today than in 2007.

U.S. debt (based on Treasury issuance) has roughly doubled since 2007 and is about 4 times higher than in 1995.

Starting in 2008, the U.S. has consistently been running monthly deficits.

The number of Americans on food stamps is almost twice as high as in 2007.

The balance sheet of the European Central Bank has ballooned by about 100%.

The Dow measured in the currency that’s hardest to manipulate (gold) is lower today than in 2007.

Election Year “Bonus”

This year is an election year. The incumbent party will do what it takes to stay in the drivers seat and the Fed (and ECB) won’t hesitate to resuscitate.

Is it money well spent? Wall Street will tell you yes. 46 million Americans on food stamps will beg to differ. Wall Street feasts on prime rib while the average Joe is stuck with the “Fed’s sausage.” No food stamps needed.

Bernanke – 5 Minutes Away From Losing Your Trust?

Bernanke is the most powerful man in the financial world, but is he also the smartest of them all? A look at his bloopers shows that he’s respected not for his smarts but for his …

Ben Bernanke is an American economist.

Ben Bernanke is a self-proclaimed student of the Great Depression.

Ben Bernanke was a tenured professor at Princeton University.

Ben Bernanke is the chairman of the Federal Reserve.

Ben Bernanke is the most powerful man in the financial universe.

But is Ben Bernanke smart? The kind of smart that’s needed to get the U. S. and global economy back on track?

Trust and a reputation are built on one’s track record. Let’s take a look at Mr. Bernanke’s track record. All we need is to compare history with Mr. Bernanke’s past assessment.

Bernanke in July 2005: “We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.”

Bernanke in October 2005: “House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals.”

Bernanke in November 2005: “With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly.”

Bernanke in February 2006: “Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”

Bernanke in March 2007: “All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.

Bernanke in October 2007: “It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.”

Bernanke in January 2008: “The U.S. economy has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.”

Bernanke in January 2008: “The Federal Reserve is not currently forecasting a recession.”

Mr. Bernanke’s track record doesn’t exactly inspire confidence. He’s been wrong so often, how come everyone trusts his decisions?

The trust is obviously not in his decisions as much as in the tools available to him. Here’s how Mr. Bernanke described the powers of the Federal Reserve in November 2002:

“The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.”

Aha, Ben’s ability to print gives him respect kind of like a gun slinger gets respect because of the gun and not because of what’s between his ears.

But then Bernanke claims he’s not using the printing press:

Bernanke in December 2010: “One myth that’s out there is that what we’re doing is printing money. We’re not printing money.”

Seems like even Bernanke is confused about what exactly he’s doing.

If you’ve read Andrew Ross Sorkin’s “Too Big To Fail,” the inside story of how Wall Street and Washington fought to save the financial system – and themselves, you’ll get a glimpse of Bernanke’s often overwhelmed ad hoc approach to the problems of 2008.

In all honesty, Ben Bernanke has done a good job of preventing Wall Street and the stock market from becoming unglued. Despite all of his bloopers, he’s no dummy … and he has a financial bazooka.

Unfortunately his allegiance is to the financial system, not to the average Joe. And after decades of overleveraging, the financial system seems too big to let fail and too big to bail by one man and his bazooka.