Why May 2010 Feels Like July 2007

by: Stephen Castellano

We exhorted our readers to adjust their portfolios toward a net short position Wednesday evening, May 5, 2010. Our "Moderate" model portfolio strategy moved to 80% long / 120% short from 120/80. Our "Aggressive" strategy moved to 50% long / 150% short from 200/0. For those that did not act on the suggestion, we continue to recommend a cautious stance moving forward and opportunistically reduce exposure by selling into any strength ahead.

Ostensibly our basis for the change in allocation was the anticipation of a turn in a proprietary "technical" indicator that we developed for ourselves. But if we had to provide fundamental reasons, we would just point to the increasing uncertainty regarding the potential looming domino effect of sovereign debt issues as the biggest reason. However, the technicals captured the fundamental uncertainty as volatility in the market, and that was a good enough explanation for us. Anyone reading the news could have picked and chosen any number of news stories to justify the increasingly likely risk for a market sell-off.

After the sickening action yesterday, May 6, in which the S&P 500 closed down 3.24% after a gapping down by 5.71% for a brief moment in the afternoon, it should be clear to anyone that not all is perfectly well in the markets. If any of this seems familiar, it's because investors experienced similar market action back in the summer of 2007. Investors will recall that the increasingly frequent volatility that began at that time eventually gave way to a 37% decline for all of 2008. Anyone not living under a rock over the last three years must be thinking the same thing. We concretely illustrate these thoughts in the table below; certainly no one wants to go through that again.

Whether it is some kind of pending domino effect of sovereign debt defaults, likely future high inflation, accusations of fraud by the captains of the financial industry, a persistently high unemployment rate, a likely slowdown in China, hedge fund blow ups and closures - it really does not matter. The fact is, the markets are rattled, and the negatives are now at the forefront of our collective mind, and risk aversion will once again become the focus.

There will be lots of ups and downs over the next few weeks or months, but the general direction, in our opinion, will likely be down as corporations and people reassess their risk levels and act to protect themselves. For example, employers that were on the fence with regards to hiring probably have just set their timetables back at least another six months for a "wait-and-see" mode.

It has been our recent experience that whenever the market has declined a cumulative 5%, the best thing to have done in retrospect is to have gone completely to cash and patiently waited for a long signal, as indicated by our proprietary technical indicator. For the month-to-date, the S&P 500 is down 4.93%.

While the past cannot predict the future, we can take these signals, chatter and recent experience under advisement - which is that it is prudent to more conservatively manage the risk ahead of us. As for completely closing out our already under-weighted long portfolio positions, we are undecided for now -- we will give that decision another day of thought as we study exactly what happened today on May 6.

For those not interested in trading every potential intraday high and low in the market, we suggest that in general it is probably a good idea to sell a portion of investments into any strength and take a more conservative stance moving forward.


(Click to enlarge)

Disclosure: No positions