Give In To The Dark Side

Includes: XLF
by: Cam Hui, CFA

Further to my last post (see An unconvincing breakout), stocks have continued to move higher. I continue to be concerned about this advance. The negative divergence (update link here) that I outlined is still not confirming this rally. Moreover, heavy insider selling is generally not a good sign for the bulls (see Insider selling, it's baaack! and this update from Bloomberg).

Risks are fading
Nevertheless, stocks continue to move up and sometimes it's more important to analyze the reaction to the news event than to analyze the news event itself. The market has shrugged off concerns over sequestration cuts to the US federal budget, as well as concerns over how political paralysis in Italy might affect the integrity of the eurozone. In fact, the storm clouds are lifting.

First of all, the House of Representatives passed a bill to avert a March 27 government shutdown and kick the can down the road to September 30. No doubt there will be further horse trading in the Senate, but the risk of a near-term fiscal catastrophe is fading in the United States.

Across the Atlantic, the Italian "crisis" is resolving itself in a relatively benign fashion. An Italian court has sentenced Silvio Berlusconi to a year in prison for his role in a wiretap case. His brother Paolo got two years and three months. While Berlusconi will undoubtedly appeal the ruling and remains free for the time being, this development weakens him politically. In the meantime, Italian bond yields have begun to recede, though the decline has not reached the pre-election levels:

Click to enlarge charts

While I am concerned about the instability created by Beppe Grillo's Five Star Movement, Richard Gwyn, writing in the Toronto Star, made an insightful comment about Grillo [emphasis added]:

Grillo's great accomplishment thus has been to make everyone think hard, Italians themselves most directly, but almost as much all the EU technocrats and attendant financiers.

Political eruptions, like that of Grillo and Occupy Wall Street, often don't last. Very astutely, the playwright Fo has expressed the worry that what may bring Grillo down is flattery. Fo has said: "I've seen the glowing press and he must not fall for the adulation; it's a honey-like trap."

Perhaps that's what the bond market is saying: Grillo won't last.

Sentiment picture is improving
My inner trader is also pointing to an improvement in sentiment readings. The AAII sentiment survey (via Bespoke) shows that bullish sentiment collapsed in the wake of the Italian elections - a contrarian bullish reading.

A confusing market?
My inner investor continues to be concerned about this market advance. He believes that the prudent course of action would be to move his portfolio asset allocation to its policy weight, i.e. if the policy weight is 60% stocks and 40% bonds, then the portfolio should be at 60/40. In particular, he is worried about the bearish portends of insider selling. Even if equities were to advance here, Sam Stovall's analysis of what happens after the market hits a new high (via Business Insider) indicates that the upside is limited while downside risk is high.

If history is any guide, for it's never gospel, it may respond like the messenger from Marathon. In other words, the S&P 500 may have little time to rejoice following the setting of a new record high before collapsing again, as the median advance following the recovery to break-even from bear markets since WWII has been only 3% before stumbling and falling into another meaningful decline within only two months.

To chase stocks here would be giving in to the Dark Side.

Even Richard Russell, who "should" be calling for a Dow Theory buy signal after seeing new highs in the Dow Jones Industrials and Transports, is confused and he blames the Fed for his confusion [emphasis added]:

My only answer to this is that both D-J Averages produced something never seen before, namely new highs during a post-crash upward correction. My explanation of this unprecedented situation is that the advance to new highs was a direct result of never-before-seen manipulation by the Federal Reserve.

The Fed was able to engineer new post-crash highs in both D-J Averages. But I doubt if the Fed will be able to engineer a coming new era of prosperity in America. Thus, it will be an example of where the stock market will not be predicting the nation's economic future.

As a matter of fact, I believe this stock market is predicting a very mixed and confusing economic future for the US. As far as I can see, the Fed will be pumping in QE-to infinity for as long as it can get away with it. The only thing that might halt the Fed is rebukes from voting members based on it's outrageous 3 trillion dollar balance sheet. We're in uncharted territory in my opinion, and I expect to see a number of events in both the stock market and the economy which will be both surprising and upsetting.

One technical observation -- With the breakout and confirmation by the Industrials, this places tremendous psychological pressure on the 13.108 million shorts that are now positioned on the NYSE. As a result, we should see irregular spates of short covering or buying panics, depending on the fears and psyches of the short sellers. This makes shorting stocks in this market a risky game.

My view for the future -- erratic market action along with a disappointing US economy. Incidentally, I don't know if you noticed, but some of the heavily shorted stocks surged yesterday, due, in part, to frantic and fear-filled short covering.

Listen to the market
My inner trader, on the other hand, says to listen to the market and go with the momentum. The US economy seems to continue to improve despite concerns about the payroll tax increase and sequestration cuts. Last Friday's Non-Farm Payroll number was an unambiguously positive release. In addition, indicators such as rail traffic point to continued growth in the economy.

So it may be the time for my inner trader to take a walk on the Dark Side and get long this stock market, though with tight stops. I have a suggestion for those who want to take that walk on the Dark Side. While the logical course of action may be to buy cyclically exposed stocks and industries such as the Materials sector which seems to be staging a bottom (see Time to buy gold and commodity stocks), here is an even Darker suggestion.

Recently, Attorney General Holder admitted that big banks are "too big to jail":

U.S. Attorney General Eric H. Holder Jr. told lawmakers that some financial institutions have become "so large" that it makes it "difficult for us to prosecute them."

Holder's admission bolsters criticisms that federal prosecutors are deeming some banks "too big to jail," a charge that lawmakers and consumer advocates have routinely made in the wake of recent bank settlements. Although the government has issued record multimillion-dollar fines in these cases, critics say without criminal charges, the agreements amount to a slap on the wrist.

Robo-signings? Banks are systemically important. Robo-foreclosures? It's just a few bad apples. LIBOR scandal? No problem.

That, my friends, is considered to be an unassailable competitive advantage for the financials. The real walk on the Dark Side is to buy the large cap financials, not despite, but because of their propensity for financial shenanigans. Consider this chart of the relative performance of the financials against the market. This sector broke out of a long-term relative downtrend in early 2012 and they have begun a relative uptrend.

The benefit of being long this sector is that it provides a less cyclical exposure to the stock market and will partially insulate the trader from a downturn in the economy. In any case, if you are going to take a walk on the Dark Side, you might as well go all-in.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.