Riding the rally

March 17th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Right on the money?

* Sideline money - returning to the risk game

* Riding the rally

In last week's post I concluded with some words of caution about making any short bets on the S&P 500 index. The price action since then has shown that I was right on the money. Perhaps this was a case of being right for the wrong reasons or perhaps there is something to this technical analysis lark. Either way let's review which of my calls worked and which didn't.

On the short-side, last week I identified a pattern of negative RSI divergence which had been in place since mid-January, and a clear break below the index’s rising channel.  Last week’s chart below:

However I also cautioned that the short-term signals were bullish, in particular when looking at the key Fibonacci levels since the index made an intra-day bottom at around 1340 on Tuesday 6^th March. The chart I showed indicated that the index had quite easily broken through all the key Fibonacci levels:

I pointed out that the next important resistance levels to watch for on the S&P would be at the 100% retrace level (1378) and following that at the rising green trend line.

One week later, and it appears that the levels I identified did indeed prove to be significant.

The short-term chart below shows that 1378 on the S&P provided some initial resistance in early trading on Tuesday 11^th March, with the market ‘gapping up’ on opening and meeting that level almost exactly. After briefly falling back, the market had pushed through this level of resistance by mid-morning.

  

The next target for resistance which I identified, the lower band of the rising channel, also appears to have held some significance for the market, being approximately the level at which the strong rally of Tuesday 13^th was stopped out. This is highlighted in the chart below by the black circle.

Importantly, the lower channel actually provided support to the index on Wednesday 14^th and since then has closed above the lower channel for two days (Thursday 15^th and Friday 16^th). It could be that the index is now re-entering the original trading channel, or a new trend may be forming. Either way what is clear is that the market has shrugged off the recent correction and is looking to push higher.

Another reason to expect further gains in the short-term is that the RSI has bottomed and is now indicating bullish momentum, as highlighted in the chart above.

One call I got completely wrong was on the VIX ‘fear index’. Since last week’s post where I made a case for a spike in volatility on the basis of RSI divergence, the index has fallen 15% and is now trading below the trading channel I originally identified. The VIX is now 16% lower than when I first wrote about it, and 30% below its 1990-2012 average:

The current VIX levels indicate an element of market complacency which gives me some cause for concern. In the medium term, significant economic and political headwinds exist (some of which I identified here and here) and I maintain a bearish outlook within this time horizon.

However, in the short-term I am bullish due to a combination of the S&P technical indicators discussed above and my expectation that risk assets will continue to benefit from the current climate of easy monetary policy and massive liquidity injections by central banks.

"Sideline money"

In addition I anticipate institutional ‘sideline money’ re-entering the market during March and April, providing significant support to the current momentum in equity markets.

The reason I say this is that elevated Eurogeddon tail risk during the past few months has caused many asset managers to shield their client portfolios by going underweight equities and increasing allocations to cash. Their resulting benchmark underperformance means a great deal of pressure for these managers to boost returns during Q2.

With the risk of a ‘disorderly’ Greek default now off the table (at least for the time being), I expect this sideline money to flood back into the market as asset managers seek to get back in the game by loading up on risk. This wave of buying should provide support to the rally and should counter-act any end-of-quarter profit-taking and portfolio re-balancing by the large institutional players.

Riding the rally

There is undeniably a great deal of risk out there, however this is the case for every bull market. Rather than shy away from risk, a successful investor must accept the fact that uncertainty and the unknown are inescapable – they are fundamental characteristics of investing.

In the short-term we should look to ride the rally, remain flexible and be ready to adjust portfolios according to the changing technical and macro picture.