Seeking Alpha
Portfolio strategy
Profile| Send Message|
( followers)  

The recent extreme volatility of financial markets, and the seeming variability of global economic and financial conditions, are proving to be a source of confusion for many investors. Many investors are at a loss regarding what to do. Both markets and events seem to be pulling them in different directions.

What a given investor should do in the face of current circumstances depends on many factors. One of those factors relates to the time horizon that the investor adopts as his/her point of reference.

Investment strategies that do not incorporate specific time horizons are deficient. And forecasts that do not state explicit time horizons are useless.

In this regard, I would like to address questions posed by many readers regarding my most recent article. In that article, many investors seemed confused about what I was saying or what I was doing when I said that the market may rise in the short term. Given my very emphatic bearishness regarding the medium-term prospects for global markets, many readers interpreted this as some sort of contradiction or “flip-flop.”

The confusion arises because investors are not used to thinking about market action within distinct time-frames. Markets can go up in one time-frame and go down in the next and go up in yet another. A stock market prediction is only correct if the direction and general magnitude of the move is correct and it occurs within a specific time frame.

The Short-Term Outlook

In my most recent article I pointed out that for the next few days, and perhaps through the next six weeks or so, the U.S. equity market has several things going for it. I will summarize them here:

1. Sentiment/Portfolio rebalancing. The consensus was very bearish going into the EU summit and portfolios were positioned accordingly. It will take time for this bearishness to be worked off and for the market to enter into a more normal equilibrium.

2. Fed meeting buzz. Some have speculated that the Fed will take further measures to support the mortgage and housing markets.

3. G-20 Summit. The market participants expect international coordinated measures to be announced that would assist Europe.

4. Further policy measures in Europe. Investors expect that clarification of details of the announced road map will solidify confidence.

5. U.S. growth hanging tough. I expect most measures of economic activity in the next month or so to be unsupportive of predictions of recession issued by several high profile pundits.

None of this means that anybody should make an investment on the basis of these factors. Short-term traders may take these factors into account, amongst many others as they decide whether to place a trade.

The Medium Term Outlook

I define the medium term as a distinct period of time whose outer limit is greater than one month out but less than 12 months out. This could be a time frame such as three to nine months or a period between 10 days and 11 months. The important thing, from the point of view of forecasting, is to define the exact time frame.

In several articles I have defined the medium term for present purposes as a maximum of six months into the future. In my view, the outlook over this time frame is troubling.

Specifically, it is my view that the market will initiate another major leg down within that time frame and will subsequently test the recent lows of 1,075. It is my view that this test is likely to be unsuccessful and that the market will test 1,020 and perhaps as low as 950 on the S&P. This scenario assumes a severe deterioration of the situation in Europe and globally due to a failure of the current plan to limit financial contagion to the other PIIGS (Portugal, Ireland, Italy Greece and Spain), but does not contemplate outright defaults of major countries in Europe such as Italy or Spain. Such an outcome would merit a lower target.

Thus, the nature and scope of my prediction is the following: There will be another leg down in the market that will initiate within the next six months, which will cause a test of 1,075. This next leg down could start five months and 29 days from now, it could start in a few weeks, or it could start today.

Reconciling Different Outlooks Within Different Time Frames

But am I contradicting myself? Didn’t I say that the market could rise in the short term?

There is no contradiction here.

First of all, there is no contradiction in saying that a market may rise before it falls to a specific level within a specific period of time. As long as the market ultimately initiates a move within six months which tests the 1,075 level, the prediction will be accurate. If a move that takes the market to 1.075 is not initiated within this time frame, the prediction will prove to be inaccurate.

Second, despite the fact that I have pointed out that the market may rise in the short term, I have made it clear that it would only be appropriate for traders with short-term time frames to attempt to capture any of that potential upside, if it materializes at all. For investors with longer time frames, I have made it clear my opinion that chasing this rally would be a mistake.

Thus, I want to make it absolutely clear: I have not made a call to buy stocks in the short-term. My call is that investors with time frames that exceed a few days or weeks should raise cash. My explicit actionable prediction is located within a medium term framework which I have defined as six months. Specifically, I have predicted that the next leg down in the market will commence within six months and that investors should prepare accordingly.

Conclusion

Investors need to stop thinking in terms of markets going up or going down. Depending on what the time horizon is, the markets will virtually always go BOTH up and go down relative to where they are right now. Investors must learn to think in terms of specific time frames.

In this case, my view is that investors will have better opportunities to buy stocks - even attractively value stocks such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC), at significantly lower levels. Specifically, I believe that investors will have a better opportunity to purchase these stocks when the market has retested and/or broken below recent lows of 1,075 on the S&P 500 (^GSPC).

In this regard I would will quote myself at length and reaffirm what I said in an article published on October 27, 2011:

I have no hesitation in remaining in cash and short-term bonds even if the U.S. market rallies back to 1,340 or beyond. It is far preferable to leave 10%-20% upside on the table than to risk downside of 30% or more. Furthermore, in the medium term, short-side opportunities look far more attractive than long-side opportunities.

Thus, I believe that the correct posture at the moment is for investors to be entirely in cash, or at least equity neutral via paired trades and/or hedges.

Even if Europe manages to get by and markets are substantially higher six months from now, it will simply not be worth it to have assumed the risks posed by equities at the present time. I do not believe that even the perspective of hindsight could alter this assessment in the future.

Quite the contrary. Equity investors will likely find themselves in the position that existed in mid 2007. By mid 2008 these same equity investors were wondering how they could have been so foolish to have remained long stocks, or even to have increased their equity exposure, despite very clear signs that the global financial system and economy was irreversibly about to experience a major crisis.

Greed, which is just another form of fear (fear of “losing out"), is an extremely powerful motivator. It takes courage to stray from the stampeding herd. This is one reason why preservation of wealth is so difficult.

The question is this: Do you have the courage to stand aside and possibly leave 10%-20% or even 30% on the table? Or would you rather not take the “risk” of missing out on that gain - even if it means assuming the possibility losing 30%-50% when and if the European plan unravels?

U.S. stocks (SPY, DIA, QQQ) are at reasonably good values. Indeed, they are quite cheap relative to bonds. Many stocks such as Apple, Microsoft and Pepsico (NYSE:PEP) look attractive on a long-term basis. However, it is my belief that these stocks will get much cheaper. And even if they don’t, over time, the markets always provide investors with many opportunities.

Investors do not have to take advantage of every single “opportunity” in order to be successful. In equity investing. There is no such thing as any particular moment representing a “last chance.” In particular, it is my view that investors do not need to be in any rush to assume the sorts of historic risks involved with equity investments at the present time.

Source: What Should Investors Do In This Market?