This is a re-post from an article we wrote for TheStreet.com:

The rally off the March 8th lows has been nothing but spectacular.   In hindsight, it’s clear that investors overreacted to the downside, but as stocks surge more than 50% it’s time to begin pondering whether the current rally is a bit ahead of itself.  Contrary to my bottom call on March 8th when I said it was time to invest in risky assets (a full history of my 2008/9 calls can be found here including our 2008 crash call and March 8 buy call), now is the time to put on your risk management cap as a number of various threats begin to pop up across the market.    I recently turned near-term bearish on stocks due to 2 primary reasons: sentiment & seasonality.

1)  Sentiment – As I often say, psychology drives markets.  After months of skepticism regarding the rally we are finally beginning to see an overwhelming amount of bullishness.  This is a screaming contrarian indicator.  The latest consumer confidence readings showed a marked jump to 54.1 and bullish sentiment among fund managers has soared to its highest level since 2003:

The latest Merrill Lynch fund managers survey shows an extraordinary jump in optimistic sentiment.   The survey makes up the current psychology of 204 portfolio managers running over $550B in assets.  The report shows a 63% jump in sentiment since July and the highest reading since November of 2003.

After months of short squeezes and failed market declines this optimistic sentiment has begun to eat into one of the fuels of this rally: short sellers.  Recent short sales data shows the lowest readings since the market tanked in early February.  As we lose the short sellers we lose an important driver of higher prices.

Perhaps most important has been the enormous shift in analyst estimates.  After turning bearish in early June, I reversed the position in early July for one reason – earnings.  My analysis led me to believe that estimates were far too low primarily due to the fact that analysts were not accounting for cost cuts.  The estimates have been outrageously low, but now as the consensus begins to believe in a full blown recovery the earnings estimates have spiked.  My proprietary expectation ratio (see below) measures actual earnings vs analysts expectations.  It is an intuitive forward looking indicator.  It turned negative in late 2007 and went positive in late 2008 for the first time.  The indicator shows the likelihood of earnings outperformance going forward.  Although the indicator is still firmly positive we are beginning to see a dip as analysts play catch-up and increase their estimates.  It will be very important to keep tabs on any changes as earnings season approaches in case sentiment continues to shift higher.

2) Seasonality – Seasonality is an important driver in any market.  Unfortunately for the bulls, we’re entering a two month period where seasonality tends to have a negative impact on particular markets.  As a risk manager who has just witnessed a 50% move in equities I have to ask myself whether the increased risks in the market require a reduction in overall exposure to high beta assets?  The overwhelming answer here is yes – primarily due to two markets: housing and oil.

According to the Stock Traders Almanac, the best periods to be an investor in real estate and energy stocks is between November and July with average returns of about 17% since 1954.   Seasonality in these markets is powerful for fundamental reasons.  In the oil markets we generally see strong seasonal strength as winter sets in in the latter portion of winter.  This is quickly followed up by the spring and summer driving season which is followed up by hurricane season.  All three lead to increased demand for energy and generally higher prices.  In the housing market the strong trend is the spring and summer buying season.  The back to school season and winter time are notoriously weak times for real estate and the data tends to reflect that.

With industrial materials and energy stocks now representing 24% of the S&P 500 you have to be careful about where oil prices are headed.  Not only has OPEC been very vocal about keeping oil below $80, but a disappointing hurricane season could drive a lot of speculators out of the market in the coming months.

If oil were to make a sharp move lower it would be very difficult for the overall market to overcome the downdraft.

Housing has been the most important leg in the recovery.  If we begin to experience the strong seasonal trends in the fall and winter (as we have each of the last 3 years) we could begin to see housing data disappoint to the downside.  This would certainly put a dent in the v-shaped recovery idea and the belief that housing prices have bottomed.  With a mountain of foreclosures in the pipeline, weak seasonal trends and the first time home buyers credit ending we are likely entering a much more difficult period for real estate.

Although I still believe equities are likely to march higher into year-end (as I predicted at the beginning of the year) I believe the next few months could prove to be turbulent, if not treacherous.  Manage your risk accordingly….

Cullen Roche

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