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The Case for the Countertrend Rally


But playing it can't be done with tight stops.

Editor's Note: James Kostohryz was formerly the head of international investments for a major Brazilian investment bank.

In terms of fundamentals, my case for a major countertrend rally -- outlined in Is a Countertrend Rally Inevitable? and many of my writings in Buzz & Banter since early March -- is proceeding nicely.

Yesterday, we had better-than-expected retail activity, reflected in restaurant sales. In addition, yesterday's data revealed inventory draw-downs and better inventory/sales figures.

Today we have news out of Japan, which is an important part of my thesis: Machinery orders rose +1.4% on the month in February (after a record 4-month run of contractions), versus the -7.9% drop forecast by economists. Furthermore, yesterday's restaurant data were confirmed today by a slew of retail companies reporting better-than-expected same store sales for March.

My thesis describing the gross undervaluation of the banks outlined in Are US Banks Worthless? is perhaps not sounding so ridiculous any more. Bank of America (BAC) has more than doubled since I wrote about it in late February in Bank of America's War of Independence. These banks have value, and I expect that today's news out of Wells Fargo (WFC) is just going to be one of many more "wake up calls" that are going to be causing people to reevaluate their thinking about the banks. (Investors may consider possibilities such as XLF, UYG, FAS, BAC, JPM, MS).

Implied volatilities reflected in the VIX are declining and are now below 40. I've been expecting this. And unlike many, I see this as a hugely bullish, as it signals receding risk aversion. With the VIX at current levels, risk aversion is still high, and the VIX would have to get into the 20s before I'd get concerned about risk complacency. This means that the market has a great deal of room to rally before one needs to get concerned about that.

Indeed more broadly, I believe we can potentially see a declining VIX as a leading indicator of consumer and investor sentiment - which should translate into a pick-up in consumer spending and investment in the second quarter.

With everything that we know today about Fed and Treasury policy actions, as well as the improving economic data -- none of which were certain in early March -- this market is a more compelling buy today than it was in early March, when I went from 0% to 100% invested.

I believe that this market is going higher - much higher. Investors may consider ETFs, such as SPY, SSO, BGU, UWM, TNA, QQQQ and QLD. However, I will reiterate my belief that this rally cannot be played effectively with tight stops. Stops must be kept wide to allow one to be able to absorb the volatility.
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