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It never stops to fascinate me how market perceptions can violently swing in a short period of time in financial markets. About a month ago many were expecting 2011 to be another 2008 with credit markets seizing and growth falling off a cliff. Charts comparing the two periods and analyzing further downside in relation to the great recession were common. Today we are talking S&P 1'600 (and other large numbers) after a 13.5% rally in October. It's happy days again.

I made a call to go long risk in the early days of October when gloom was abundant (We're Bottoming: Time To Accumulate) - after the big reversal day on Tuesday the 4th. Let us revisit the arguments from a month ago, as they remain key drivers going forward.

1. Sentiment

Sentiment is no longer at an extreme. In the space of a month it made a violent swing from very bearish to neutral. The bears have been stopped out or postponed their bearish forecasts until next year. The financial calamity that was to some extent expected a month ago hasn't materialized and this fact to a large extent drove the rally.

2. Europe

The gloom in early October was largely due to the European crisis - the inability of the authorities to come up with a solution. Many important details of the solution are still not known (private sector involvement in Greece or EFSF leverage/capacity, for example). We have also learned time and again that European authorities tend to overpromise and underdeliver. Will this time be any different? The key point in relation to last month's performance is that a framework to fight the credit dislocations in the Eurozone is in place, and some time has been bought.

3. Recession risks

Recession risks - especially in the US - have clearly diminished. We have seen a string of positive surprises starting with ISM Manufacturing (1.1 points better than expected), ISM Services (0.2 points better), payrolls (43k better), retail sales (0.4% better MoM), Philadelphia Fed (18.1 points better!), and finally, a Q3 GDP number that matched expectations of 2.5% annualized growth. Are we out of the woods with strong growth ahead? Maybe we could get a few more good data readings by just continuing this trend.

4. China

Given that over-tightening and hard landing were considered the main risks in China, there has been positive news. We now speak of 'fine-tuning' the policy and 'selective credit easing'. The tough housing measures have been branded as 'temporary' for the first time and premier Wen Jia Bao said in comments that 'jobs' were a priority (until recently it was fighting inflation). Chinese and Hong Kong policy stocks have responded positively.

5. Valuations

This space was dominated by the earnings season. In the US, 818 companies reported a positive surprise vs. 342 missing expectations, with growth of 15.8% YoY. This is not the stuff recessions are made of. Unfortunately, I don't have any data on guidance (how many have raised vs. lowered), but the earnings season appears to be beating expectations.

6. Technicals

As mentioned in the Merril Lynch/Bank of America fund manager survey recap, positioning going into this month was very bearish (bottom quartile of the last decade, maybe even bottom decile) with high cash balances and low equity exposure. These fund managers are scrambling to get into the risk trade now as the underweight positions are painful - chances are this has further to run.


I would be taking profits here on around half of the long risk position for two reasons 1) the belief that more than 50% of the rally is behind us and 2) it's good to have dry powder shall the month of November present fresh opportunities. As often happens, we may have a rally into year-end, but the most explosive part is behind us.

Europe will continue to be a troubled case and newsflow will be mixed at best. There are plenty of risks regarding implementations of the EFSF, final agreements on the PSI, bank recapitalization (it seems like the banks on an individual basis do not want more capital because it's dilutive to existing shareholders, even if they acknowledge that as a group they need more capital to bolster confidence) or simply undershooting fiscal targets and growth by European governments.

We have avoided another 2008, but the outlook is not particularly great with fiscal tightening in many economies next year, a possible recession in Europe and generally weak growth. It is not time to forget about these things by only focusing on the recent price action. On a medium term basis (6-12 month view) this rally is a time to reduce your exposure. Maybe today is a good time to start.

Source: Where We Stand After The Rally: Outlook Not Great