October has dealt risk investors a nice bear market (or counter trend, if you prefer) rally. As we pointed out last week, these are not uncommon and are just as sharp (large magnitude, short time frame) as the more familiar bull market correction. So, although there is no catchy “buy the dips” analogue, one should think about “selling the peaks”.

But what about the positive noises coming out of Europe and retail sales in the US?

While there is a slim possibility that the lows plumbed at the beginning of the month will mark the end of the bad news and the beginning of a new bull phase for risk assets, the Fund King System suggests that the momentum is just not there yet. Much digital ink has been spilled on the subject of “short covering” but the real story is that many funds were underinvested in terms of risk. The rally has been fast and furious because these investors have been scrambling in the past 5 or 10 trading sessions to participate in the rally in an attempt to patch up otherwise dismal performances for the year. Even legendary investor Bill Gross (a.k.a. “The Bond King”) has been compelled to play catch up. However, once European leaders fall short of hopes for a bank recapitalization on November 3rd and/or the next US data point on employment or retail sales disappoints, the momentum will fade quickly.

Where’s the ceiling?

This rally is all about emotion so there is no reason why it should not end at the otherwise arbitrary 200 day moving average for the S&P 500 (currently around 1276). With a 16% rally from the October 3rd close in their pockets, look for institutions to scamper for safety by lowering their exposures to risky assets once again.

As we advised last week, by all means participate in the rally but do not confuse a bear market rally with the start of a new bull market. Be prepared to return to a defensive posture on the sidelines as soon as momentum breaks down. If you only wanted to watch one indicator, the S&P500 (SPX) at 1276 would be the number to watch.

Other important factors

The most important development over the last few weeks is the announcement by ECRI that the next recession is imminent (if we are not already there). ECRI does a very good job at calling the big turns in the major economies (and, perhaps more importantly, avoids “false alarms”) because business cycles are their specialty.

One should also revisit some of the implications of the unavoidable Greek default on other EU countries. In his letter from a trip to Ireland, John Mauldin reminds us that the Irish expect to be able to renegotiate their situation in line with the terms offered to the Greeks. Expect a few more “nasty surprises” to surface in the wake of the default.

Fund King Portfolios

The various portfolios have taking a bit of a hit in the last few weeks, especially relative to the major equity indices. However, the ratings and rankings suggest that the counter trend rally will be short lived and we are due for a return to pre-October market conditions.

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