Lowering Beta

Tue, Oct 27, 2009 - 12:57pm

With the S&P closing lower on Tuesday, "the market" is now down five of the last six days, and has struggled to form a sustainable short term low. This is the kind of tape action I feared several weeks ago when I wrote the column, "Rolling Defensive" and expressed the idea of bringing down beta (i.e. volatility levels) in the portfolio. As I noted in last week's column, the market has likely entered an extended consolidation phase, where price action will be erratic, and gains difficult to sustain. I stated,

"Right now I believe that while the rally of the last few weeks has been terrific, it is now largely complete with a consolidation phase dead ahead. The consolidation phase is the market's way of issuing a 'seventh inning stretch.' In my view, the chances are very high that the upcoming pause will last anywhere from three to five weeks, most likely encompassing most of the month of November. In fact if I had to guess, I would venture a strong guess that for the next four to five weeks the S&P straddles 1100 with a range of 20 to 25 points either side. Call it 1075 by 1125 with a 50 point spread centered around 1100."

So far, the market has pressed the low end of that range and extended recent losses as far down as 1160 with the bulk of the last day or so worth of action bounded between 1065 and 1070. As we write, the S&P finished the session at 1063, and now appears generally poised for a recovery rally, possibly a sharp recovery rally. In my view, a run back to the upside toward 1,100, or even to new highs in the area between 1120 and 1130 is not at all out of the question. Unfortunately, even if a healthy advance to the 1100 area does develop, I suspect that the staying power of those gains will be quite illusory. On the charts, I note that the McClellan Oscillator for the big board ended Monday evening at a reading of -401.63, down from –263.10 on Friday of last week. This is consistent with, or at least with one final down day of the kind of ultra oversold readings seen at some of the other important lows in 2009 including: the –618.55 on 10/2, -476.81 on 09/02, -352.68 on 8/17, -320.12 on 07/08, -464.64 on 06/16.

Above: the McClellan Oscillator for the broad stock market now very oversold on a short-term basis. This implies a rally near term, one which will likely see the S&P push above 1100 in the next 4 to 7 trading days.

Above: Short Term Up to Down Volume

In addition to the McClellan Oscillator, which is based on Advances and Declines, my near term indicators which track the Ratio of Up to Down Volume are also substantially oversold. While this can never guarantee a rally, in my view it suggests that a rally of reasonable quality should soon be at hand and as a result, I would maintain outstanding long positions and avoid hedging at this time. For those who are positioned on the long side of the market, understand that we are now in the late inning of this advance. If the S&P does get a nice lift from the present short term oversold values, the upcoming rally and especially a 'break out move" to new highs would be the kind of strength that would be ideal to sell into. Selling into strength is often a difficult task, as it is hard to walk away from any good party. Unfortunately, as the economic data shows, the downside action in the underlying US economy is still quite pronounced, with many earnings reports and conference calls referring to the poor quality atmosphere which exists.

Jim Cramer pointed this out on Mad Money the other day, noting the use of the phrase "albeit at lower levels" something I totally agree with, and which implies that there are more chickens to come to roost in 2010. The easy money has been in the stock market for 2009, at least on the long side, and punctuated moves to higher highs from here will likely carry fewer and fewer stock groups with each ensuing thrust. Bull Market dies of upward exhaustion and the exhaustion of group rotation. While this advance may yet manage to 'hold up' into early December, I doubt the S&P will manage much better than 1150, and at that level, risk levels will be ultra high.

Under the category of defensive sectors, the somewhat lower beta Utility sector holds a reasonable amount of interest at this stage of the game. As risk assets have boomed in the last six months, Utility stocks have been shunned and have underperformed. This is reflected by the huge sell off in the relative strength ratio of Utilities to the S&P shown in the middle graph below. Importantly, that move has now gone a long distance in a relatively short period of time, with the medium term RSI based on the Relative Strength Ratio now fully oversold (see lowest clip). This hints that the Utility sector may start to outperform as institutional capital begins to seek out the relative protection of higher dividend yields, which in many cases for the Utilities are on the order of 4 to 5%. That beats money market, and provides some yield protection should equities begin to roll over.

Above: GST Utility Index (top clip) Relative Strength Ratio of Utilities versus S&P (middle) and Wilder RSI Medium Term Momentum Gauge (lower clip).

Above: GST Utility Index (upper) and Utility A/D Line (lower)

So far Utility stocks have not yet proven themselves with a burst of buying power, and in the days ahead, we will be watching the tape action as manifested by the Advance–Decline Line of the Utility space. A break out to new highs in this gauge would suggest that money is flowing into the sector and that the market in general is adopting a more defensive tone. Finally, healthcare has also long been a favorite in transition phases, and to that end, Healthcare has been one of the most consistent performers in recent weeks. For now, with earnings reports thus far showing high levels of stability in this space, the outlook for Healthcare stocks remains generally constructive. One of our more aggressive contrary opinion bets of late has been a sub-sector of Healthcare, the Managed Care space which virtually everyone has loved to hate. A few weeks ago I pointed out the very substantial oversold values that existed in this space where the Intermediate A/D Ratio reached fully oversold values as did the Medium Term ARMS Index.

Above: GST Managed Care Sector with Intermediate A/D Ratio

Looking at Managed Care through yesterday's close, we see that the Relative Strength Ratio of HMO's to the S&P was all the way down to the 200 day lower Bollinger Band, an extreme if ever there was one. Thus, some level of satisfaction with the stocks all ending materially higher in today's trading. For the next few weeks the key idea will be to manage risk, employ defensive stops and make sure that you bring down beta in your portfolio.

Above: GST Managed Care Index (upper) and Relative Strength Ratio of Managed Care versus S&P 500 (lower)

Above: GST Healthcare Index (top) and Healthcare Index versus S&P 500 Relative Strength Ratio (lower clip)

That's all for now,

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