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Is the Risk-On Trade Dead?


It's all about probabilities of occurrence and the weight of evidence.

There are so many things I need to know, there are so many things I got to know. Tell me, tell me, won't you tell me; and then tell me again.
– "Crystal Ball," Styx

The end to a short month:
  • European/Italian election disappointment.
  • Sequestration forefront on investors' minds.
  • Volatility reappearing its ugly head.
  • Pushing the top of the fourth secular channel (100-YMT).
  • And, to tuck it all into bed, a mid-week key outside reversal day for the four sister indices (Dow Jones (INDEXDJX:.DJI), S&P 500 (INDEXSP:.INX), Nasdaq-100 (INDEXNASDAQ:NDX), and Russell 2000 (INDEXRUSSELL:RUT)).
Is the risk-on trade dead?

Since the last political infighting – fiscal cliff – ended nearly two months ago, the market has seemed rather tranquil; no real fiasco-related pitfalls on a far-reaching basis. This is not to downplay some of the tumultuous individual disasters, but they have mainly been localized to individual securities and based on earnings. Notwithstanding, my firm got caught in one last week -- Chemtura Corp (NYSE:CHMT), 13.5% opening gap-down debacle from earnings; so much for our 31.5% unrealized profit since November 2012. Oops. But these misfortunes traditionally cannot be helped. As much as we'd like to believe it, we do not own a crystal ball.

During the 2013 "peaceful" drift higher investors have heard plenty of pundits beginning to clamor about a break into new "all-time" highs, equating to a break above my firm's 100-Year Market Theory's Fourth Secular Channel. Can it be done? Will it be done? Is there enough dry powder left to push through? These are good questions, but let's pose one from the other side. What's the immediate (short-term) drawdown risk? It's all about probabilities of occurrence and the weight of evidence. As our CFO always says, "I do not see the glass half empty or half full, I only see the glass." Interesting way of putting things, wouldn't you say?

Click to enlarge

Since the S&P 500 Index rebounded off the intermediate-term channel lows (black dash) in late November 2012, it has developed another shorter-term bullish trend within (blue). Now that it is pushing against the top of the intermediate-term bullish channel and the top of the macro long-term secular channel, the technical weight of evidence suggests a potential pullback, but to where? Assuming the latest short-term trend is breached, the first logical support is around 1,450. If the storm clouds continue, the next technical stop is most likely the bottom of the longer term channel (~1,400-10% drawdown). This preponderance of evidence gives us two leading points to consider in our "weight of evidence."

Click to enlarge

The beginning of this editorial discussed a key outside reversal day. Some technicians call it a bearish engulfing. Regardless of the name it technically portrays a day which begins higher, reaching a higher high than the prior day, and closes lower or at the lows, lower than the day prior's lows; essentially, bad news for momentum. When this happens on a trend high, on high volume, and "engulfs" more than one day prior, it makes it a "key" reversal day or key bearish engulfing. On Wednesday last week, it not only happened to one sister, it happened to all four, and looked like a bear mauling its first meal after coming out of hibernation. (See what I did there with that pun?)

This event caused major concern on the technical landscape and principally became the shot across the bow announcing potential rocky waters ahead. For my firm, this does not mean reallocating every portfolio to cash or even a market-neutral stance for that matter. Yet it does put a call out to all investors to find and secure their life vests as there's not nearly enough to go around if (or when) the time comes.

This analysis may not come from a crystal ball, but it sure does beat dwelling over the "I should have..." thoughts, post-trauma. Short-term greed is beginning to take over as investors don't want to miss the next possible leg of the market. It's the picture-perfect beginning of straight-line thinking. And, for one last weight to set atop our evidence scale, this type of thinking simply adds further credence to the contrarian view.

With all this said, my firm will not officially announce a shift to a bull-neutral stance until the short-term trend (blue) has been broken. So, if you like to play in the wind (volatility) on the chance that it won't rain, have fun -- but know where your umbrella is.

I hope this helps and finds you well.

Editor's Note: Read more at Tesseract Asset Management.

Twitter: @TAM_News
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No positions in stocks mentioned.

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