Tuesday, May 10, 2011

Sell in May?

In the wake of the commodity rout last week, the Inflation-Deflation Timer Model has moved into "neutral" from an "inflation" reading*. This told my inner trader that he should take some risk off the table. Given the high level of macro risk, I would be inclined to take more more defensive position than usual.

This signal to de-risk isn't a surprise. In early April, I wrote about negative divergences (see Getting ready to sell in May). How the market reacts to news is also a good short-term indicator of direction. The fizzled Osama bin Laden rally should have been as clear as ringing the bell in the town square to traders that this market was looking tired.

What happens now?
Now that the Timer Model has gone neutral, what happens now? Mr. Market could take one of two paths.

First, this could be the start of a run-of-the-mill 5-10% correction in the equity market, with an extreme downside limit of about 15%. VIX and More has tabulated the market pullbacks in the 2009-11 period and the average depth of these correction was 6.5%.

Macro risks everywhere
I am concerned that the market is acting vulnerably during a period of heightened macro risk. There are three major sources of macro risk:
  • Europe: As I write this, Greek 2-year debt is sporting an eye-popping yield north of 25%. These stratospheric levels reflect market fears that bond holders will have to take a significant haircut on Greek debt, which would be a devastating blow to the already fragile European banking system. If Greece re-structures, then it could very well take down Spain - which may be too large for the EU to rescue.
  • China: The PBoC has signaled that it will take further steps to cool its superheated economy and there are "no limit to how far it can raise the reserve requirement". Already, there are signs that its property bubble is being deflated. Recent reports indicate that Chinese property developer profits are falling and their debt is approaching $1T in a climate of rising inventory.
  • US default: The political horse-trading over the debt ceiling continues to be worrisome. A default by the US Treasury would send shockwaves all around the globe and it would be the financial equivalent of the comet that hit the Earth and created the Gulf of Mexico in prehistoric times.
The current market environment is likely to resolve itself with a plain vanilla 5-10% correction. However, if any of these macro risks were to manifest themselves during that pullback, the downside has the potential to extend itself to 40-50%.

My inner investor has already heeded these warnings and de-risked his portfolio. My inner trader is inclined to be more defensive than normally called for.

* The announcement of signal change was delayed on this blog out of consideration for the clients of Qwest Investment Fund Management.


FIFO said...

No arguments with you here. The MULT has been in steady decline since the first of the year and money creation is having no effect on providing lasting upside market momentum in commodities which has been the market leader.

I have reallocated my commodities position drastically down 4 weeks ago when the anticipated rally from the massive amount of money creation from the Japanese earthquake carried little market momentum in the sector.

Since then I have sold out of base commodities and oil and down to zero cost core positions for my gold holdings with one exception.

I now have much larger cash, bond and some health care in my allocation.

Cam- I have to thank you for leading me to the fed data info on the St Louis Fed website awhile back. It is a treasure trove of information that has help me actually time the market with success.

Trust - Me said...

Reaching the debt ceiling is not the same as defaulting. A default is the stopping of payment of principal. Reaching the debt ceiling will ONLY prevent the issuance of new debt. So the government will not be able to meet certain obligations, wages/services/entitlements, but will continue servicing existing debt. Like someone maxing out their credit card, the stores that person frequented will no longer be paid, but the person will not be in default unless he stops paying the credit card company.