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Tuesday - August 21, 2012 Market Thoughts

Stocks rallied this morning, carrying the major indices to or near 52 week highs. The euphoria for the bulls slowly faded as a steady stream of selling reversed early gains sending stocks to a loss on the day. The S&P 500 closed the day with a loss of 0.4% and the NASDAQ fell by 0.3%. Volume picked up on both exchanges although was below average. There were some characteristics of churning as volume picked up with price making little progress and finally closing lower. The day also was a bearish engulfing pattern in candlestick charting. The VIX closed the day up 7%, a strong move considering the limited move by the S&P 500. This may be a signal of traders positioning for future weakness. It should be noted that the VIX started moving higher prior to any significant weakness this past spring.

We initiated a hedge in the portfolio today. The market has enjoyed a very strong rally since June 4 and is now reaching overbought levels. Sentiment appears to be leaning too far to the bullish side and complacency is also high. The fear trade has partially left the bond market as the ten year note has gone from 1.38% up to 1.87% over the past 3 weeks. Although yields are still historically low, the move in percentage terms is massive. With all these factors, the market has to have near perfect news going forward for the rally to be sustained. Considering the number of issues facing the market, which are well documented, perfection seems to be a stretch. We see this area as a good risk reward for a hedge to be initiated. If we are wrong we will likely remove the position 1-2% above today's highs. We see the potential for a correction of 2-5%, minimum, and a higher probability of a 5-10% correction. A larger correction would be much more likely given the volatility experienced since the 2009 bottom.

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