Summertime Stock Strategy: Buy The Cascade, Sell The Charade

by: Eric Parnell, CFA

The old trading adage on Wall Street goes as follows:

"Buy the dips, sell the rips"

In other words, by buying low and selling high, investors can make money regardless of the broader market trend.

But in today's investment environment polluted by years of extraordinary monetary policy actions, the stock market can prove wildly unpredictable at any given point in time. And whereas the principles of fundamental and technical analysis would traditionally drive investor decision making, today we have a climate where stocks rise or fall dramatically merely on the desperate hope for another money printing fix from the Federal Reserve. If the Fed is applying balance sheet expanding stimulus a la QE, stocks float dreamily higher. But once the Fed printing presses stop, a nasty hangover for stocks quickly ensues. Interesting times indeed.

So where do we stand today in this Fed dependent market? Since October 2011, the Fed has been implementing a semi stimulus program. Instead of balance sheet expanding QE, the Fed has instead been engaged in balance sheet neutral Operation Twist. Under this program, the Fed buys longer dated Treasuries from banks with maturities ranging from 6 to 30 years. But to prevent the Fed's balance sheet from explicitly expanding, the Fed offsets these purchases by selling shorter dated Treasuries that are set to mature within the next 3 years.

While it is perceived that the stock market has responded well to Operation Twist, this has not been the case when taking a closer look at market performance. This is due to the fact that the European Central Bank launched its own balance sheet expanding program known as LTRO during the time period when Operation Twist was in place. If one excludes the stock market performance during this LTRO phase and also sets aside the initial rally that occurred at the very beginning of this latest Fed program, the stock market has actually been down fairly meaningfully for much of Operation Twist.

So what can we expect going forward? The U.S. Federal Reserve provided markets with a great deal of clarity surrounding its course of action for the remainder of the year. Operation Twist was previously set to expire at the end of June. And some investors had been anticipating that the Fed would launch another balance sheet expanding stimulus program in QE3 given the recent signs of global economic stress. But on Wednesday, the Fed announced instead that they would simply extend Operation Twist through the end of the year. By taking this course of action, the Fed effectively took one of their final two options off the table. Thus, the Fed's strategy apparently sets up as follows. Continue to implement balance sheet neutral Operation Twist through the end of the year in an attempt to keep markets stable. But if the global economy and its markets start to careen toward crisis, implement balance sheet expanding QE3 to stem the tide.

Given that the market is highly addicted to QE, this sets up the following summertime trading strategy for stocks:

"Buy the cascade, sell the charade"

Several principles are core to this trading strategy. Under Operation Twist, the stock market is likely to grind back and forth just as it has for the last many months when the program has stood on its own. But at some point during the summer, it is very possible that economic and/or geopolitical conditions could deteriorate dramatically and shock the markets. While a crisis outbreak in Europe is the leading candidate, a destabilizing event in the Middle East is also a distinct possibility. It could even be some other episode that is currently unforeseen by the markets such as the unexpected collapse of a systemically important financial institution, a geopolitical event such as a terrorist attack or even a natural disaster.

Any of these circumstances could send the stock market cascading lower. Such an outcome certainly would not be unprecedented, as we've seen similar episodes play out during the summers of 2010 and 2011. And once any cascade lower is fully engaged, this would likely be the time to actively consider buying into the market. This is due to the fact that the plunge lower is the required event for the markets to get the QE3 stimulus program it so desires. And it will likely be because of the sharp market downturn that the Fed will relent and launch QE3.

This brings rise to an important question. Exactly when is the best time to buy under a market cascade scenario? While a sample of two is clearly insufficient to draw any definitive conclusions, the implementation of policy stimulus is a product of human decision making at the Federal Reserve. Thus, past precedence provides us with a general sense of what we might expect. In both 2010 and 2011, the moment the cumulative decline associated with a sharp stock market decline crossed below -15% from its previous peak, the Fed would step out and begin making explicit statements that additional monetary policy support would soon be on its way. In 2010, a variety of Fed officials began making statements at the beginning of July suggesting that the Fed was actively debating QE2. And in 2011, the Fed announced on August 9 that it would keep interest rates locked at 0% through mid-2013 and suggested additional policy support would be forthcoming.

If this -15% correction trigger were to hold true the next time around, this would imply a that the key range that would extract a QE3 announcement from the Fed would be a plunge to the 1150 to 1200 level on the S&P 500 (NYSEARCA:SPY). Thus, this would be the range where one should consider buying the cascade.

But what about the sell side of this trade? Since the beginning of the financial crisis, the stock market has reacted euphorically the moment it gets word its receiving its monetary policy fix. And at least initially, it is reasonable to expect the same knee jerk response from the market. But such a rally would likely be yet another charade for the following reasons. Recent history has clearly demonstrated that monetary stimulus programs such as the Fed's QE are unsuccessful in generating a sustained economic recovery. Instead, they do nothing more than lift the market into a sugar high that subsequently crashes once the juice is taken away. So while the market may rally strongly on any QE3 announcement, none of it will be founded in any real substantive improvement in the economic outlook. Instead, it will all be just another market charade that will most likely end badly.

This raises another natural question. Exactly when is the ideal time to sell the charade. During the past two stimulus driven recovery episodes in 2010 and 2011, the stock market managed to rally by +20% before encountering renewed headwinds that led to a period of consolidation. Thus, targeting a +20% charade advance from a cascade bottom would be a pragmatic approach in working to realize gains without overreaching.

Standing poised to move to the sidelines sooner rather than later under any charade rally may be particularly prudent this time around. This is due to the fact that the marginal impact of each successive round of monetary stimulus has become less and less pronounced. And the Federal Reserve along with other global central banks run the risk that we will soon reach the threshold where any positive effects from balance sheet expanding monetary stimulus will be overwhelmed by the negative effects of the crisis it is intended to combat. For once the market loses the crutch that monetary stimulus always drives stocks higher, the subsequent downside in stocks could be extensive and painful as they descend toward the final secular bear market bottom. And it is very possible that such a difficult outcome could occur with QE3. Of course, the silver lining associated with such a scenario is that final result at the end of this cleansing correction would also likely be the dawn of a new secular bull market.

As we wait for any stock cascade scenario to develop over the summertime, it is worthwhile to remain hedged against a variety of potential outcomes along the way. This includes continuing to hold asset classes that can continue to rise regardless of the direction of the stock market such as Agency MBS (NYSEARCA:MBB), U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP), Build American Bonds (NYSEARCA:BAB) and Municipal Bonds (NYSEARCA:MUB). Given the potential for a sharp stock market drop in the coming months, holding negatively correlated asset classes such as Long-Term U.S. Treasuries (NYSEARCA:TLT) also has merit. In addition, Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) also represent important hedges against both crisis and further monetary stimulus, as both typically perform well when stocks are falling around either of these outcomes.

Maintaining an allocation to stocks is also important in such an environment. And in advance of any cascade scenario, it is prudent to focus on names that are of high quality, have low price volatility, provide growing dividend income and trade at attractive valuations. Representative names include McDonald's (NYSE:MCD), Nike (NYSE:NKE), Procter & Gamble (NYSE:PG) and Hormel Foods (NYSE:HRL).

It remains to be seen whether stocks sharply decline or not in the coming months. But standing at the ready to buy the cascade and sell the charade has the potential to provide an attractive trading opportunity in what may otherwise be a turbulent rest of the year in 2012.

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.

Disclosure: I am long MCD, NKE, PG, HRL, TLT, GLD, SLV, TIP, BAB, MUB, MBB.