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Broad-based gains for riskier assets last week, amid deteriorating economic indicators, may prove a costly lesson in the weeks ahead. Both the Dow and S&P 500 enjoyed gains in excess of 2.50% apiece while the tech-heavy Nasdaq proved the laggard among the major indexes, posting a gain of 1.12%.

Rising valuations for riskier holdings went beyond the equities space, as both commodities and riskier currencies enjoyed renewed demand. The US dollar declined against its major counterparts, excluding the Japanese yen, as the safe haven play that has proved so powerful in recent weeks gave way to riskier bets.

Modest gains for the euro and the British pound last week, which represent the worst positioned economies in the months to years ahead, suggest that price action was heavily influenced by short covering.

In the week ahead, investors will look toward the core PPI and CPI data in order to gauge the deflationary pressures under which the global economy is presently operating. Following worse-than-expected employment, housing and retail sales numbers in recent weeks, it will be especially hard for markets to recover should this latest round of data releases fail to meet forecasts.

Investors can expect especially choppy trading in the week ahead, as markets consolidate in range-bound fashion ahead of the next leg down for global assets. Medium-term positioning should maintain a bias toward risk aversion while high beta names can be used to take advantage of short-covering rallies.

Securities of Interest

Long: US Dollar, Treasuries, Safe Havens

Short: Euro, British Pound, Investment Banks, Homebuilders

Analysis

Safe haven securities remain the favored play in the weeks to months ahead and investors should take advantage of broader market rallies to establish, or add to, those positions. The US dollar and Japanese yen are poised for significant appreciations from present levels, especially against the euro and the British pound.

The prospects for growth in the eurozone and the U.K. remain exceedingly negative going forward, as debt burdens and austerity measures all but assure a violent economic contraction throughout Europe. More concerning, however, is the cash-hoarding trend among European banks, which have grown especially distrustful of counterparty balance sheets. The European Central Bank’s overnight deposit facility has recorded successive all-time record deposits on a near daily basis since late May. As yet, the cash-hoarding trend shows no signs of reversing and poses a serious threat of a post-Lehman-style banking crisis in Europe.

For US (investment) banks, the outlook grows worse alongside a deteriorating banking situation in Europe. As reported over the past several weeks, US banks remain overly exposed to European assets, both government issued and otherwise, which threaten heavy losses as writedowns ensue.

Equally, if not more, concerning is the continued hyper-exposure to mortgage-related debt securities, the values of which have been inflated in recent months through government incentives. Meanwhile, the related case against homebuilders points to severe declines for relevant stocks in the months ahead.

Investors should position themselves in a very selective manner, where weaker sectors are exploited alongside safer ones. Value plays, which, in time, may prove valueless, are best speculated on through options, which offer immediate quantification of risk over a defined period of exposure.

Long-only investors, on the other hand, should consider raising cash levels on market rallies. Indeed, the value of cash on hand is too often overlooked where investing is concerned.

Finally, Forex traders should continue to play into US dollar strength, which shows no signs of reversing in the near-term. Any rally for riskier currencies, such as that of the British pound last week, should be viewed as an opportunity to establish, or add to, long US dollar positions.

Disclosure: Author is Short MS, KBH, EUR/USD, GBP/USD

Source: Bear Market Rallies: Don't Let the Price Action Fool You