Momentum Book Update: Don't Fight the Fed

by: Leigh Drogen

Don’t fight the Fed, easier said than done obviously, but never was there a more unambiguous strategy. I don’t want to get too deep into the macro environment here, but being that it is driving this market, it needs to be a large part of the discussion.

Look, we knew this rally off 1040 in August was due to the belief of traders that the Fed would step in and do something given the horrendous employment numbers and other specific data points that were going in the wrong direction according to their view. Two weeks ago that trade stalled out in anticipation of the actual announcement of the next round of quantitative easing. And last week we saw how the market reacted to the actual announcement. Remember, the actual news is never really that important, it’s all about how the market reacts to it. Was the rally off 1040 baked into the announcement? Had traders run up commodities and commodity linked equities enough given the program that was to be announced? Obviously not.

The reaction to the news was deafening. The market surged, the dollar got crushed, traders came after any and all high beta real assets. There is real fear out there right now that the Fed is intentionally blowing another asset bubble, and that they aren’t making it a secret that crushing the dollar is on their wish list. Again, as I’ve said over and over here, we can’t make policy, we may not like it, but this is what it is, and we have to roll with it instead of complaining. The market right now is saying that the rally did not bake in the Fed’s plans, and that asset prices are headed higher.

So let’s put the macro environment aside now. An interesting aspect of this recent rally has been its ability to keep the market in a sustained uptrend for an extended period of time without correcting. Certain traders I trust have seen this as a very bullish sign, I agree. It is often the hallmark of a new longer term bull market that the indices stay very overbought for an extended period of time at the beginning of the rally. We are definitely overbought here, the market surged out of the Fed announcement on Wednesday and continued straight up into the end of the week, especially the materials sector. This was a change of character for a market than had been grinding higher into the announcement via sector rotation.

Is this a good point of entry to the intermediate term trend? No, definitely not, we are too extended here to be adding long exposure for long than hit and run two or three day trades. Will there be a far better opportunity to really plow back into this market? Yes. Will that point be at higher or lower prices? I have no clue. The one thing you need to focus on now is picking good entry points, no matter if it takes a few weeks to get it and they are at higher prices. Do not price anchor! In the scheme of things a few points on any stock is not going to make or break you if we are transitioning into a longer term bull market. Now I’m not saying that’s the case, that we are headed for a positive market the next few years, but everything the market is portraying right now says that may be the case. That may change tomorrow, and we will change our opinion when the facts change, but right now things are pointing in the positive direction.

Given that we are overbought to a pretty good degree and up at longer term resistance on the SPX (NYSEARCA:SPY) around the 1,220 to 1,230 area, I took off more long exposure this week. We find ourselves at about 35% long absolute exposure with seven long positions and one short position. Taking down risk here is the prudent thing to do as we’ve had a great first month of the quarter staying right with the indices while they surged. We are also once again right at the 61.8% retracement from the '07 SPX high to the '08 low. I don’t believe we are destine to break through this level in a meaningful way on the second try, especially given how extended we are in a straight line. This is setting up to either pullback in an organized manner for a third try with more power which I believe will break, or to stall out up here for a few weeks to a few months and set up a strong flag. I think the more likely scenario is the cup and handle, a meaningful pullback here given the euphoria and chasing that was done last week. A shakeout needs to take place for this market to set up for higher prices longer term in my belief.

Either way, we will pay attention to the short term oscillators and indicators, including the volume and breadth. One reason I believe we are ready to pull back a bit and for the cup part of the pattern is due to the fall off in market breadth.

What will we be focusing on at the point where stocks give better entry points? For the first time in a long time energy equities will be on our list, crude is now in an intermediate term uptrend and I believe these stocks are under owned. Semiconductors have broken above a long term downtrend line and look set for the next leg of this secular bull run. Gold and Silver linked equities look like they are about to explode longer term, it’s scary, wow. Agriculture is also looking great and I want in at good buy points. I’m still not too hot on retail, but the high end is performing, see Deckers Outdoor (NASDAQ:DECK) and Coach (NYSE:COH). You need to pick wisely in this sector, there are two economies out there, one for the people who have jobs and one for those who don’t. Companies catering to those who do are performing, the latter are not.

Emerging markets are just ripping and for good reason. The growth stories in Latin America, India, China, all of Southeast Asia are the real deal. Don’t complicate this, stay long emerging market banks and short domestic financials as a pairs trade, or just long emerging market financials. Don’t try to be the hero or prove the market wrong by being long the domestic side, yes they surged into the end of last week due to being extremely under owned by the rally crowd, but I don’t see them putting up meaningful performance as we move higher, there are better sectors to be exposed to.

For the week we picked up 20 basis points of absolute return but lost about 350 basis points of alpha due to a few factors. One, we were very underexposed. And two, I have not been trading well recently. Look it’s the truth, I won’t deny it, it hasn’t been poor stock selection, it’s just been plain and simple poor trading. We didn’t sell out of Power-One (NASDAQ:PWER) into the earnings surge, we didn’t sell out of iRobot (NASDAQ:IRBT) into the earnings surge, we gave back the breakout in Ebix (NASDAQ:EBIX), and sold out of ICICI Bank (NYSE:IBN) for seemingly no reason but taking down long exposure. We were unlucky having a few of our positions just completely underperform, for whatever reasons, and took stops on them, which turned out to be very smart because they went on to get smashed pretty good. This is the hallmark of a tired market, breadth starts to dissipate, fewer stocks move with the market, more begin to fail. That rising tide which lifts all boats starts to ebb.

Positions sold this week include PWER, Demand Tech (NASDAQ:DMAN), EBIX, DigitalGlobe (NYSE:DGI), (NASDAQ:CTRP), Home Inns & Hotels (NASDAQ:HMIN) and LivePerson (NASDAQ:LPSN).

Positions added this week include Apple (NASDAQ:AAPL) and Ecopetrol SA (NYSE:EC).

Be patient, don’t chase, there will be a time to load up again, don’t be scared if we go higher before we pull back, it’s all about good risk/reward, don’t price anchor.

Good hunting.

For the full book you can always visit the model portfolio tab on the blog found here.

click to enlarge

Disclosure and Disclaimer: Nothing that I say or show on this blog should ever be considered investment advice or a recommendation to buy or sell any security. The performance numbers that I post in the momentum book should never be regarded as representative of any specific client account managed by Surfview Capital, it is there solely for educational purposes and should be treated as such.