Thursday, October 6, 2011

Short Squeeze or Sustainable Rally?

After reversing on the dime from what seemed like a market free-fall on Tuesday, risk markets have been on a tear the last few days. What a move, from the intraday low of 1074, the S&P 500 index has rallied roughly 8.5%, off the Tuesday lows. Any investors that used the psychological level of 1100 as a stop loss trigger have been smarting for the last two days. Unfortunately we are among that group of investors, and it currently stings to watch the market seemingly laugh in our faces for selling days ago. To help us avoid the myopia of a few days trading activity, we make sure to take a step back and focus on our process and what we believe the bigger picture to be.

Despite the torrid rally of the last few days, we don’t think the world has changed materially. Yes, a few data points have come in less-than-horrific recently, and Europe is talking a big game again. But overall we still believe the evidence for the business cycle is skewed to the downside, the problems in Europe have not gone away, technical conditions are still broken, and valuation is not low enough to provide a healthy margin of safety. Therefore our current thesis is that the market is unwinding severely oversold conditions and short positions that had built up during this bear run. We don’t feel great about the latest whipsaw at 1100, but we are staying defensive at this juncture.