October 28, 2010 – Contemplations on Risk



1) Contemplations on Risk. The S&P 500 has risen 11 out of the last 13 trading days. Everything in my portfolio is up 50% in the last four months, except for the rare earth stocks which are up 400%. My call that the global equity markets would launch into a surprise up move driven by better than expected earnings, sending shorts scrambling, turned out to be one of the best in my career (click here for ‘My Equity Scenario for the Rest of 2010’). So far, 82% of reporting companies have surprised to the upside. It doesn’t get any better than this.

Now that everything is ridiculously overbought on a short term basis, I have to ask: What can go wrong with this party? When will investors flip from ‘RISK ON’ to ‘RISK OFF’ mode? Should I pick up my ball and go home? I’m sorry, but I am one of those guys who believes that the higher prices go, the more risk they carry, and the more volatility they threaten. Most people believe the opposite.

I see three possible near term inflection points setting up for the markets:

I) The November 2 elections. A surprise Democratic win would send the markets into a tailspin. Much of the buying since august has been driven by an expected Republican takeover of the House of Representatives. If that doesn’t materialize as promised, the punch bowl would disappear very quickly.

II) Year End. Many hapless financial advisors have bought the top of the market and then sold the bottom for the second year in a row. As a result, 30% of active managers are now underperforming the index. To catch up, they are buying this year’s hottest stocks hand over fist, driving markets higher still. This is why you are seeing so much buying concentrated in lead names like Apple (AAPL), which now accounts for an amazing 20% of the NASDAQ. Flip the page on the calendar and all this buying may end.

III) End Q1, 2011. The QEII surge continues for another five months, the S&P 500 challenges this year’s high of 1,240, and New Year cash allocations pour into the market. Then Bernanke says ‘Ha Ha, fooled you! I’m not doing any QEII because you guys already did it for me!’ We then run into a repeat of 2011 where six months of feast are followed by six months of famine. The ‘double dip’ scenario once again rears its ugly head. This is what lost decades are supposed to look like.

While I am not certain which of these three scenarios plays out, I know for sure what to do when one hits. ‘RISK OFF’ means the dollar and volatility go up, and stocks, bonds, commodities, currencies, food, and emerging markets go down. Retail participation in the equity markets shrinks to two guys sitting in rocking chairs on a porch in Arkansas waiting for their cable to get installed.

Don’t kid yourself into thinking that you can hedge against these losses, or that diversification will protect you. We live in a binary, bipolar world, and the only hedge that truly works is cash.

SPX28.png picture by madhedge