Time to Sell This Sucker's Rally?

Includes: GLD, SH, SPY
by: Playing the Ponzi

After the ferocious sell-off two weeks ago and breath-taking volatility of last week, the major U.S. indexes have staged a three-day rally. The market is now rallying towards the bottom of its technical support that broke down a few weeks ago. That support, around 1260, will likely now become resistance. A few smart commentators have suggested that both the top and bottom for the year are in place.

However, in looking back over the last 20 years - an era perhaps best defined by exponential debt expansion - there no multi-year sideways channels to be found. The express elevator seems to be perpetually going either up or down.

In the 20 year weekly S&P chart below, I've circled 5 significant breakdowns from the last 15 years where the index broke under both its upward trend and sideways support. In two situations, significant additions declines followed. In two situations, significant rallies to new highs followed. So which will this be? I suspect it will be one of the two, and not a sideways consolidation.

The bull case is basically value-driven. They say the market is cheap here, with a trailing P/E around 13 and a forward P/E around 11. However, the assumptions in place for the forward numbers remain relatively upbeat. What happens if earnings miss, followed by a contraction of the earnings multiple? Given the peak margins and record corporate profits, I think there is risk to the downside for this bullish argument.

The fundamental bear case has been laid out by many investors far more astute than I (here, here and here). What I tend to watch more closely are technical trends. One over-riding trend in recent weeks has been intense volatility. It's not surprising that the biggest down days (single day losses of 4%+) over the last 10 years occurred in bear markets. What may be more surprising is that the same is true for the biggest single day rallies. In the chart below, I've noted the S&P's 20 biggest up days (not including last Thursday). Notice that almost all of them occurred between the top and bottom of a protracted downtrend.

What do I take away from this? More often than not, high volatility occurs in falling markets - and the stronger the rally, the more likely it is to be a bear market "sucker's rally." As such, my long positions are hedged with ProShares Short S&P 500 ETF (NYSEARCA:SH).

Though long a variety of positions due to the deeply oversold conditions of last week, I intend to continue lightening long positions and layering on short positions between 1220 and 1260. SH is the simplest way to hedge long positions using a long equity play. SPDR Gold Trust ETF (NYSEARCA:GLD) has performed very well as a hedge in the recent months, though should a financial crisis hit, I expect it would suffer to some extent, as it did in 2008. There is no shortage of available inverse ETF's that can increase potential gains in the event of a downturn. Just remember that leveraged funds degrade over time, and are not designed to be held for the longer term.

Disclosure: I am long SH, GLD.