Market Performance: Impressed but Wary

Includes: CLF, DIA, JNS, QQQ, SPY
by: Sean Hannon

I remain in awe of the market. Despite a steady stream of news that is either poor or unremarkable, this market continues higher. Although we have not witnessed blockbuster, high-volume days that crush the bears, a steady climb has allowed prices to approach those of recent weeks.

Although I'm impressed with this performance, I still remain wary. At this time of year I begin poring over annual reports, and the picture is not pretty. In general, companies have strengthened their liquidity positions, yet operating metrics continue deteriorating. As margins erode, the disconnect between how companies are performing and how the markets are behaving concerns me. Either an enormous economic expansion lies around the corner or the mother of all liquidity bubbles is keeping prices elevated. Forced to pick, I lean toward the latter as I believe the unintended consequences of the monetary stimulus are laying the foundation for the next crisis.

For investors, making the determination of whether the market is being driven by liquidity or expected future growth is essential. Of the 14 indices I track, the Russell 2000, NASDAQ, Canadian stock market, Dow Transports, and FTSE have reached new annual highs and six other markets are within 2.8% of new recovery highs. This paints a picture of broad technical strength that will carry markets higher and make defensive strategies such as short-selling sure losers. Simultaneously, each move higher makes holding stocks riskier. Left with a world with few safe investments, investors must wrestle with the question of how to properly manage risk while attempting to maximize returns.

This open-ended question is an important one. If you believe, as I do, that the current market strength is not justified by the business and economic fundamentals, how do you invest? Bond and cash interest rates are so low that they offer little income. Stocks become riskier as prices head even higher. How does a prudent investor maximize gains in such an environment?

I believe there are three main alternatives. The first is to sit with your funds in cash and earn next to nothing. This approach carries little risk of loss, but also provides no return. The second approach is to project a bearish view that the markets have outpaced any level of realistic economic growth and become short of the market. As shorting into strength is a recipe for disaster, this strategy carries enormous risk. A select few will be able to execute this strategy successfully, but for most the shorts will be taken too soon and then covered when the market pushes higher, resulting in large losses. The final approach is the one I will follow - keep your eyes on the exit and realize profits quickly. We are not in an environment where portfolios can be put an autopilot, but instead time horizons and profit targets should be tightened. By taking gains when they come, we can grow our portfolios while keeping our value at risk limited.

Such a strategy has guided the recommendations made recently in EPIC Insights. When opportunities exist, we shall grab them. However, we will not let these positions go unattended and will quickly take the gains.

Two recent examples highlight this approach. On February 18, I seized upon Cliff Natural Resources' (NYSE:CLF) tendency to move in the post-earnings direction for several weeks. This encouraged the recommendation of a long position which was then increased a few days later when the shares traded above their uptrend. Upon reaching my price target I sold and the trade produced a 19% return in three weeks.

While CLF was bought for technical reasons, On February 25, I recommended a position in Janus (NYSE:JNS) for fundamental reasons as the shares were trading at a discount to fair value. Two weeks later, the gain of 14% far outpaced the S&P 500's 3.2% increase over the same time period. As the stock has rallied, the margin of safety I desire disappeared and I decided to sell.

Successful investing involves entering trades when the expected return exceeds the potential risk and then moving along once price targets have been reached. More opportunities will present themselves over the coming weeks and I will exploit them when they occur. Until then, I will keep my powder dry.

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