Time to Take Profits From This Rally

 |  Includes: AA, AAPL, NFLX, PCLN, SPY
by: Gold Digger

In my previous posts, I recommended buying shares of some companies that I thought were looking oversold and had experienced too-sharp declines in a short period. I specifically mentioned Priceline (NASDAQ:PCLN), Netflix (NASDAQ:NFLX), Apple (NASDAQ:AAPL) and some other names. However, these stocks have more than recovered to reflect their full market value and I would recommend selling these stocks now and convert stocks into cash.

The market is up sharply due to false optimism from Alcoa (NYSE:AA) earnings. The reason is simple: Alcoa earnings were upper in-line with expectations (13c vs 11c expectations). I call it "upper in-line" rather than a "beat" because beating by 1-2c is really not a beat. Any company can make those numbers legally by tweaking something as discretionary as G&A expenses.

Alcoa is expecting that in the future, lower prices will entice more demand. I do not agree with that hypothesis. Aluminum is not a metal that companies would like to store because prices are low. Commodity prices are low for a single reason: There is less demand. This is simple economics 101. Then how can a company say that demand will increase due to lower prices? Basically Alcoa tried to paint a rosy picture of a gloomy outlook for short-term future demand of base metals.

The market is expecting that earnings will not be as bad because it has sold-off sharply in past few weeks. But an intelligent investor will know that the market was selling off less due to the fear of earnings in the past 3 months but rather due to dim earnings prospects in the next 12 months. An intelligent investor is always forward looking and considers only future cash flows.

I don't think that the Euro has stabilized as yet. In fact, any run up for the Euro to $1.28 would be a good selling point. This is because we still don't know how efficiently Greece and other European countries are implementing the austerity measures that they have promised. These measures themselves will not be measurable in a time frame of less than a year, at the least. For example, pension is based on retirements and that data can be validated only with a horizon of at least one year.

The biggest problem is that fundamental consumer demand is not able to pick up because prices of everything went up too fast in too little time. India and China are still struggling to tame the huge inflation problems in those countries. In the U.S., we don't have inflation- as measured by government agencies. But their numbers don't mean anything. What is important to the consumer is his/her buying power relative to his/her earnings. So if earnings went down significantly (due to multiple reasons e.g. high unemployment or lower wages or less hours available to work, etc.) then everything becomes too expensive for the consumer; even though inflation (as measured by prices) may not have increased significantly.

So I don't read too much into any one number because there is always another side of the coin that is often overlooked.

This is the reason that I don't think minor deflation will be a problem. However, the Federal Reserve and many other economists don't want to think that way. They want to go by the books and theories and deflation is not considered good in their books. I think deflation will be very good for the economy as it will bring back the demand that cannot be sustained otherwise even after the Fed flooded banks with currency. We will have to go through a significant deflationary period throughout the world to bring the economies back to a sustainable demand and supply balance. This translates into corporate profits going back to the levels of 2002-2003. Or in simple terms, the S&P 500 reverting back to the levels of December 2002 or January 2003.

Click to enlarge:

S&P 500 10-year chartClick to enlarge
This means the S&P 500 will stabilize only at a level of about 880. Now I am not saying that we will get to that level in next 10 trading session but that is a level that I see forming as a solid base for S&P500 (NYSEARCA:SPY). So I advise investors to take profits when we see big rallies in the market. This rally is now approaching overbought levels on a short-term basis as well.

One more piece of advice about Apple (AAPL): I think there is increasing uncertainty about iPhone 4. When a company tries to bring an untested product to market and tries to defend it, that means they are under enormous pressure to defend their market valuation. So I am advising not to buy Apple shares until we get clarity from the company.

Disclosure: No position at the time of writing