Absolute Return Portfolio Management LLC

Equity Market Overview

On October 19th I wrote my first warning about the stability and viability of the bull market advance. At that time the S&P 500 was at about 1100. Six weeks later, on November 27th, I wrote again that a significant market top was forming. At that time the S&P 500 was still at about 1100. Today, almost three months later, the S&P 500 is only at 1136, about 3.5% higher. Yet, some sentiment measures are now issuing the starkest warnings of not only this bull market, but they have reached high risk levels not seen in many years.

At present, there appear to be three possible outcomes: 1) the markets are continuing a process of developing a bull market ending long-term top, 2) these warnings are pointing to a forthcoming wide, drawn-out trading range which will consolidate 2009's gains over the next quarter or two or 3) we will experience only a modest short-term correction of 5-7%.

Frankly, the picture has become more muddied since mid-October's first warning because market internals have improved since mid-December. Internals are still not robust enough to paint a picture of health but they aren't as bleak or as critically weak as had existed through November. This seems to suggest that the six week stall between October and late November did much to alleviate the pressures that were building.

As mentioned, it is the sentiment measures that are presently showing the excessive expectations that generally coincide with significant market peaks. What is interesting is that the warnings are coming unanimously from a whole host of different measures of sentiment. Each giving the same stark warning. For example, the Investors Intelligence weekly survey of professional newsletter writers has shown fewer than 20% bears for eight consecutive weeks. In other words, over 80% of respondents are long-term bulls. At the previous bull market top of July 2008 only a couple weeks of  less than 20% bearish weekly readings occurred. One has to go all the way back to 1987, before the crash, to equal such low readings in this indicator. Such an extreme polarization of sentiment is rare and points to an extended trading range or market top.

Similarly, the AAII weekly sentiment survey of amateur investors is showing very low levels of bearish sentiment; again highlighting the wide-spread optimism that generally accompanies market tops. It's of interest to note that the last reading of 2009 showed a ratio of bulls vs. bears greater than 2-to-1. The last time such a drastic polarization of sentiment occurred was at the bull market peak of October 2007 and subsequently in August 2008 which was a significant interim peak before stocks plunged in the financial sector melt-down.

This week, too, the CBOE Equity Put/Call ratio is pointing to an interim or greater top having remained at extreme levels for seven consecutive trading sessions. Options are generally used by unsophisticated speculators hoping to use the leverage of options to make fast and easy money. However, the overwhelming majority of options speculators, over 90% by some studies, lose money. So, when the ratio reaches extremes it indicates that speculation is running rampant.

Finally, the Rydex Asset ratio has reached its most extreme level of the entire bull market and levels not seen since the peak of the market in October 2007. This particular indicator measures the amount of money going into various Rydex mutual funds. Rydex offers bull funds and inverse funds to allow investors to play both sides of the market. Rydex caters to traders and their cash flow data offers a unique perspective into crowd behavior. Presently, the extreme reading is occurring because so few investors are betting on a decline compared to those that expect the market advance to continue. Again, such polarizations of sentiment frequently coincides with market tops or trading ranges.

On the whole, the extreme readings of many sentiment indicators coupled with fair to weak market internals seems to suggest that the highest probabilities suggest a wide trading range or modest correction rather than a worst case scenario.

However, I expect that even if the best case scenario plays out there is presently 5-7% downside. Should a trading range develop over the coming quarters it would suggest 7-10% downside. In either case, caution is warranted.

International Equity Regions

The performance of International investments is driven by both local market performance and currency changes relative to the US Dollar (USD). Strength in the USD translates into currency losses for US-based investors and has the effect of reducing the performance of overseas investments.

I had noted in the previous issue of November 27th that sentiment towards the US Dollar had reached an historic extreme and that a rally in the US Dollar was quite possible. As it happened, the USD had bottomed the previous day and rallied over 5% before settling back recently.

The effect of the USD rally had been a stalling in the performance of overseas equities markets relative to domestic equities. However, a higher trend in the USD is anything but a foregone conclusion. The intermediate and long-term trend of the USD remains DOWN and my expectation remains that foreign equities will continue outperform their domestic counterparts until proven otherwise.

If the USD is able to reassert itself, and turn the intermediate-term trend models positive, it may require a re-allocation of our allocation between domestic and foreign equities. This depends in part on the aforementioned currency component as well as local stock market performance. For many years, the foreign markets, especially those of Asia, Latin America and other Emerging regions have significantly outperformed the USA. It is possible that even with USD strength these markets may continue to outperform domestic equities. In such a situation, the performance advantage of foreign equities would be narrowed.

At present, we are running about a 3-to-1 ratio favoring foreign equities. Should USD strength continue, and depending upon local foreign market performance, it may require a re-balance of our allocations between foreign and domestic equities. Given that there are two variables (local market performance and USD trends) it would require a lengthy discussion of all possible alternatives.

This can be simplified greatly by simply evaluating the performance of foreign equities versus domestic equities in USD terms. At present, relative performance trends still favor foreign equities.

US Equity Markets (Equity Style Model)

Small and Mid-cap stocks began their typical seasonal out-performance going into year-end. Very recently, this trend is showing signs of turning over suggesting a movement back to the safety of large-caps, particularly the value segment, which typically coincides with market tops.

Investment Grade Bonds

High Grade Corporate and International Bonds issued a SELL signal in December. We saw some furtive strength earlier this month but the bond market hasn't been able to maintain its footing.

High Yield Bonds

Our High Yield Bond model is on a BUY.

Inflation Hedge / Real Assets

In our last issue of November 27th I posited "if nearly 100% of people are already bullish on Gold, and have presumably bought, who is left to buy now and push prices higher?" Well, gold peak just a few days later and appears to be continuing to consolidate its gains from April of last year. Gold must still be defined as being in an uptrend BUT remains overbought/overextended. More time and/or price decline is needed.

Commodities have finally moved out of a long consolidation that started last summer. This could soon be an area for investment again. The weakness in the bond market, signaling inflationary concerns, coupled with this renewed strength in commodities seems to paint the same inter-market picture of increasing inflationary expectations.

Currencies

We sold the remaining half of our Australian Dollar position due to the US Dollar rally. At present the model has gone to a cash position. This indicates that their exists neither a strong uptrend in foreign currencies nor a strong uptrend in the US Dollar.

Overall, it appears that foreign currencies have peaked and the US Dollar is working on building a prolonged uptrend. As noted in the International Equities section, the intermediate-term trend of the USD is still defined as down so I need to see a little more strength before committing to the long of the USD.

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