Time To Sell Like It's 2008?

Includes: SH, SPY
by: Playing the Ponzi

After three months of volatility, the S&P rallied almost 11% in October, its best month since 1974. Strong Q3 earnings combined with stable economic data and surging hope for European debt resolution to push markets dramatically higher. The Bulls have re-emerged and Bears have beaten a hasty retreat. But before jumping on the “long and strong” bandwagon, have a look at the bigger picture. Behavioral investing and technical analysis are based on psychology, and the idea that the ebbs and flows of investor behavior tend to repeat. To that end, the most recent rally in U.S. markets is eerily similar to a rally that took place in May of 2008.

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In both cases, the S&P formed a "head and shoulders" top over the course of 6 months, followed by a severe breakdown. Several months of intense volatility came next, including a push to new lows, only to reverse into a fierce rally. In both 2008 and 2011, the rally carried the S&P back to the original "neckline" of the head-shoulders-formation (the rough price of the original breakdown). In both cases that "neckline" coincided with the 200 day simple moving average.

So are we re-playing 2008? That's the 64 Million Dollar question. Though history repeats, it never repeats in quite the same way, which is what makes the chart similarities so odd, and suggestive of similar a psychological pattern. The systemic risks in 2008 and 2011 are very similar. Private debt concerns have morphed into public debt concerns, but in both cases, the worst case scenario involved systemic collapse. In both cases, the first dominos were falling (Bear Sterns, Greece), but no larger players had yet. Fear of impending recession was a factor in both situations (moreso in 2008 than today), but the market maintained hope that dire fears were just that and nothing more. In both cases, that hope for both resolution and continued growth is what fueled the rally back to the 200 day moving average.

Most of the market's current attention has been focused on risk emanating from Europe. I get the impression that most market participants tie the risk of recession to a resolution of the European crisis. The ECRI does not. They have been unequivocal in their call for an impending recession. The ECRI growth index has matched the lows of 2010 (well below historic recession levels), and while the ECRI flatly stated during 2010 that they were not calling for a recession, this year, they have been equally assertive that they are expecting one. From their September 30, 2011 press release:

Last year, amid the double-dip hysteria, we definitively ruled out an imminent recession based on leading indexes that began to turn up before QE2 was announced. Today, the key is that cyclical weakness is spreading widely from economic indicator to indicator in a telltale recessionary fashion.

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The ECRI statement concludes with this note:

It’s important to understand that recession doesn’t mean a bad economy – we’ve had that for years now. It means an economy that keeps worsening, because it’s locked into a vicious cycle. It means that the jobless rate, already above 9%, will go much higher, and the federal budget deficit, already above a trillion dollars, will soar.

Here’s what ECRI’s recession call really says: if you think this is a bad economy, you haven’t seen anything yet. And that has profound implications for both Main Street and Wall Street.

By May of 2008 when the market fiercely rallied back to its 200 day moving average, the ECRI was already forecasting a recession (and were considered late in doing so), though official recognition that the U.S. was in recession didn't come until December. Once again, the market has rallied fiercely after an ECRI forecast of recession, though there is far less common agreement this time around. The ECRI's track record is pretty well known – they've correctly called the last three recessions without any false alarms. Their past success doesn't guarantee future success, and they could certainly be wrong this time around, but it seems that their warning is at least worth careful consideration.

It can be argued that the risks are much greater now than in 2008, since so much financial and political capital has already been spent. There is far less tolerance for an "at-all-costs" remedy to save the financial system, should it come to that. The credit markets have not corroborated the latest equity rally. Combine these factors with the fact that the S&P is coming off its biggest month in over 30 years and is now testing significant technical resistance, and I think the time for “risk off” is now.

Taking profits in recent winners or hedging a long position by layering in some SPY puts or short ETFs like SH seems prudent to me at this time. The downside risk remains acute, while the upside potential may well have been largely realized in the month of October. Should the market continue to march higher and securely settle comfortably above the 200 day moving average, I may be encouraged to take a more bullish stance in the short term. But until then, I believe caution continues to be warranted.

Disclosure: I am long SH.