Stocks: One More Flicker Before The Lights Go Out

Includes: FXY, GLD, MBB, SLV, TIP, TLT
by: Eric Parnell, CFA

Stocks have suffered a brutal May so far. After bouncing back to an intraday high of 1415 on the S&P 500 on the first day of the month, stocks have plunged by -7.8% in the days since. And the drop has been unrelenting along the way, with declines in ten out of the last twelve trading days. With the situation in Europe increasingly deteriorating toward crisis, it is easy to build the case that the current decline could have much further to go. Perhaps this will be a correct conclusion in the end. But in the meantime, the stock market is overdue for a bounce.

The stock market has simply fallen too far, too fast. For those that have followed my articles over the last year, I have long contended that the stock market rally that we experienced from early October to early April has been entirely built on sand. In fact, the global economic outlook is worse and the European crisis is far more unstable today with the S&P 500 trading at 1305 than it was back in October 2011 when the market was trading at 1075. The rally over this time period was driven almost purely by monetary stimulus including the Fed's Operation Twist and the ECB's Long-Term Refinancing Operation. But the LTRO is already over and Operation Twist is set to end in June. And until the Fed and the ECB have sufficient reason to launch another stimulus campaign, further air is set to deflate out of the stock balloon.

Despite expectations for further downside in the months ahead, stocks are now overdue for a bounce. But any such reversal would likely be driven by technical factors. For example, the S&P 500 Index now has an oversold Relative Strength Index (RSI) reading of 25. This marks the lowest level since August 2011. And in the eleven past instances when the S&P 500 had an RSI reading approaching 30 or less, stocks subsequently bounced sharply higher. The key differentiation across these past episodes, however, is the duration of the reversal. Some have been sustainable, while others have been fleeting. Given that Operation Twist is likely to end soon with no new stimulus program on the board and Europe still crumbling, any rally this time around is likely to fall into the fleeting category.

So what will be the likely catalyst for the reversal? Perhaps it will be the Facebook (NASDAQ:FB) IPO. Perhaps it will be some allusions to policy stimulus from a Fed governor in the coming days. Perhaps it will be the classic "European policy makers say they are committed to resolving the crisis". Perhaps it will be something completely mechanical that the media will try to attribute to a better than expected PMI reading in Uzbekistan. Regardless, a bounce is likely in the coming days, perhaps as early as tomorrow or early next week depending on how long traders wish to be heading into the weekend.

But if the rally materializes, it should be viewed with the perspective of using the opportunity to lock in gains. The global economic outlook remains sluggish at best and the situation in Europe is deteriorating by the day. And investors are not likely to wait as they have in the past until after the Fed's stimulus program ends in June to take action. Most everyone knows what happens to stocks once stimulus goes away, and unless a new program is promised between now and June, the rush for the exits is likely to pick up pace somewhere along the way.

In terms of positioning, I began actively closing out equity and preferred stock positions at the beginning of April. As a result, I am less hedged than in the past with the objective of benefiting from a declining stock market and the purpose of being more tactical as we move toward the end of Operation Twist. I have also raised cash allocations along the way to provide portfolio flexibility. My only stock positions at present are McDonald's (NYSE:MCD), Tootsie Roll (NYSE:TR) and WGL Holdings (NYSE:WGL), although I may add tactical long positions to selected stocks or broader market ETFs in the coming days. For example, a trade in Apple (NASDAQ:AAPL) is a distinct possibility in this regard, as valuations are reasonable and it is not often that the stock reaches such oversold levels.

The primary portfolio focus remains on those areas of the market that are either suited to perform well regardless of the direction of the economy and the stock market or stand to specifically benefit from a stock market decline. This includes core positions in Agency MBS (NYSEARCA:MBB), which has consistently risen since the beginning of the financial crisis and is the likely focus of any future Fed stimulus program, and U.S. TIPS (NYSEARCA:TIP), which have also been steady gainers due to the dual characteristics of inflation protection during periods of growth and safe haven status during times of crisis. Positions that are designed to benefit directly from a stock market decline include Long-Term U.S. Treasuries (NYSEARCA:TLT) and the Japanese Yen (NYSEARCA:FXY). Lastly, I remain long both Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) for a variety of reasons that I intend on expanding in a set of upcoming articles.

Stocks are overdue to rally. But if it does, it may well prove to be the last flicker of light in the current rally before darkness fully descends on the stock market. Thus, it remains worthwhile to stand ready to capitalize on any bounce in the coming weeks before we enter what may be the next murky phase of the market cycle.

Disclosure: I am long MCD, TR, WGL, MBB, TIP, TLT, FXY, GLD, SLV.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.