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.

What is the “Occupy Wall Street” movement angry about? Our $0.02
1. Massive organized fraud is committed by Wall Street firms with respect to the subprime mortgage market.
2. Despite knowing the risks of the collateral they were creating, most of these firms ran into serious trouble, and asked for a bailout. Almost all got it.
3. The Finance lobby played an enormous role in writing the new regulations designed to prevent this sort of blow up again (Frank-Dodd). These regulations have gone from reasonable to neutered.
4. The heads of many banks are incredulously disdainful of those who suggest that banks should be subject to more scrutiny and cap requirements.

The current economic morass we find ourselves in is the penance we are forced to serve for the felonies these individuals committed, and the incompetence they exhibited in managing the subsequent risks. If this doesn’t make you outraged, nothing will.

Although the S&P 500 has managed to break through its short term obstacle, setting up a Bear Market Rally, the fundamental picture darkened just a bit more over the weekend.

The Economic Cycle Research Institute (ECRI) is now calling for a recession. While there is a chance that they are wrong, the ECRI has a pretty impressive track record both for calling the major turns in the economy and for not issuing false alarms. For those of us without a full membership, we need to rely on articles from the New York Times. But, the ECRI calls are generally ahead of the pack so even hearing about them a few days late puts one ahead of market concensus.

Source: ECRI

As you trade the Bear Market Rally, be ready to head for the exits as soon at momentum starts to fade.

Although we look for fundamental reasons to explain the results that the Fund King System kicks out, occasionally we must cast a glance over the charts to see what they are telling us.

The first chart which stands out as we get ready for the week’s trading is a point and figure chart of the S&P 500 Index. As the leading index for risk assets, we would expect most other risk assets to follow the SPX’s lead in the short term.

Source: Bloomberg

The beauty of the Point and Figure Chart is that it removes time as a variable and concentrates on the absolute movements and reversals in the market. As you can see at the tip of the big arrow, we are at a crucial psychological juncture for the SPX index. If the market reverses and starts putting red O’s down, market participants are likely to interpret that as a continuation of the trend of lower highs and lower lows. If, on the other hand, it can break through to the 1190/1200 level, we could see a trip back up to the 200 day moving average.

Source: Bloomberg

A word of caution, though. With the Euro Crisis far from resolved and signs that China’s property market is in a cooling mode, the market for riskier assets is still looking at more potential negative than positive developments in this low GDP growth environment (particularly amongst developed economies). Current conditions seem to echo the first part of 2008 when the markets recovered from the initial shocks of what became to be known as the Global Financial Crisis.

Source: Bloomberg

What should investors do?

The current readings on the various Fund King Systems that we monitor still suggest a cautious stance. That is unchanged since the beginning of May which means that hopefully we have all set aside some cash which is ready to jump on a good opportunity.

As suggested above, we could be approaching an inflection point which would allow investors to participate in a strong counter-trend rally. That strong rally would not be out of place as we approach the back part of the year and into January. However, one should keep an eye on the index vs. the 200 day moving average. Unless we see some movement towards solving the big Sovereign Debt issues that plague the market, the rally should run out of steam as it approaches the 200 day MA mark.

The last few days have seen a strong counter cyclical rally. Will it continue?

I like Point and Figure charts because they remove the element of time. As you can see, the last few movements in the market have been very bearish (lower highs and lower lows). If this rally (represented by the green “X”s can break out and form a new trend, then perhaps this rally will prove to be sustainable.

If, as is likely, the Europeans get hung up on their most recent efforts, the market is very likely to resume its downward trend.

The point and figure chart makes it very clear what the S&P500 has to achieve if it is going to get out of its recent bearish rut.

Source: Bloomberg