As regular readers know, between March 2 and March 5, with the S&P below 700, I went from 90% cash to a 100% core long position. In my article, Is A Countertrend Rally Inevitable?, I fully explain my rationale.

On a trading basis, I exited the position on April 15 when the S&P was at about 845, for reasons I reviewed in Anatomy of a Losing Trade. On May 19, as outlined in MV Weather Report: Winds Blow S&P to 1000?, I resumed the position with the S&P at around 900 for reasons I fully fleshed out in Why the Counter-Trend Rally Can’t Be Stopped. At that time, I built a portfolio consisting of stocks such as BAC, MS, JPM, AAPL, RIMM, PALM, GOOG, IO, YGE, JASO, SPWRA, WFR, BRCM, QLD, and SSO, as well as various options positions on these and a few other stocks.

Ever since I published my first articles on the countertrend rally, I've been consistent in stating that the window for the countertrend rally would be in the June-July period. Consistent with this long-held view, since mid-June, I've been expressing increasing caution regarding the market for reasons outlined in various buzzes and articles (see all articles and buzzes published since June 16).

On Wednesday, as outlined here, with the S&P between 925 and 933, I essentially liquidated my entire core long position. In the following article, I explain why.

Fundamental Factors

1. Reversal of the pent-up demand effect.

Perhaps the single most important fundamental insight that drove my countertrend rally prediction was that production and shipments had contracted far more sharply than underlying demand. I outlined that case in Surprises Continue to Drive the Rally, and again in Why The Countertrend Rally Can’t Be Stopped. Economists and equity analysts projected the October 2008-February 2009 production declines in a linear fashion into the future, and this produced massive estimation errors. It was clear to me that once the psychological panic phase had passed, production and shipments would not only normalize in line with true underlying demand, but there would also be a pent-up-demand effect that would “juice up” the economic and corporate data from March through June.

According to my research, the pent-up-demand effect alluded to above has probably run its course. But that, in and of itself, isn't the main problem. The problem is one I predicted in the 2 articles cited above: Economists and equity analysts have once again made the mistake of projecting linearly. They have taken second-quarter figures and projected forward from there. The problem is that the true level of normalized underlying demand is below that which was reflected in the data in the second quarter of 2009, due to the pent-up-demand effect. This means that once the pent-up demand effect wears off, demand will quickly settle back to a lower normalized level. Not only that, from this lower normalized level, aggregate demand is still contracting at a fairly rapid pace due to declining employment, real wages, and profits.

In sum: The third quarter and particularly, the fourth quarter, are likely to bring substantial disappointments in economic data and corporate earnings.