Near-Term Caution

Our near-term investment thesis continues to be bearish. We have been writing for several weeks that we expect a shallow correction, perhaps 5% to 7% from the peaks in March. Truth be told, we have been extremely surprised by the resiliency of the U.S. equity markets in the face of what looks like a European Debt quandary that plagued market returns through the second half of last year.

That said, the European equity markets appear broken, southern European sovereign debt yields are rising once again and spreads against the German ten year are widening.

In addition, the deterioration in cyclical sector performance and pricing and volume action for the major indices, we remain defensive and bearish in our portfolios.

In our stock portfolio, we had taken profits and scaled into a short position by the start of the month, thus we are expecting solid results for April. In our enhanced yield portfolio, we continue to carry our income producing instruments but have aggressively tilted the beta of the portfolio with a downside bias, thus we should see capital gains as well as income this month. Our separately managed accounts (SMA) are sitting in cash currently after taking the last of our profits in March. We will remain on the sidelines until our market models dictate re-entry.

We expect further downside and have adjusted our portfolios appropriately.

JSK Behavioral Model

Our proprietary behavioral model will score within one of five basic market cycles. These cycles include “Extreme Euphoria”, “Greed”, Rational Market”, “Fear”, and “Extreme Panic”. Depending on where we are in the market cycle determines how aggressive our portfolio structure. Typically, the best time to be conservative is when we are falling from the Greed - Extreme Euphoria cycle as we are today.

As we can ascertain from the current readings from the model, both the trigger and trend line are trending lower. This is not a good sign for market bulls.

We will monitor this model daily and start to increase our bullish long exposure as the orange trend line starts to move higher. Until that time comes, we will remain bearish and defensive.

Sector Rotation

One important observation has been the performance of the financial sector. It has clearly been the worst performing sector in April, down approximately 4.7%. Technology and energy stocks also fell aggressively. We will be looking to these sectors for leadership coming out of the current correction.

Our cyclical/defensive index has also turned lower from recent peaks. When the trend line in this model is increasing, economically sensitive industries are outperforming economically defensive industries. This is a bullish sign. The opposite is true now.

We would like to see strength return to financials and cyclical stocks before taking a bullish position. Until that time comes, we remain defensive and bearish.

Pricing and Volume

We made a quick note last week about pricing and volume action. We wanted to elaborate a bit further this week as it has meaningful implications to further market direction. We downloaded a snapshot from our Bloomberg terminal and labeled it figure 4.

The last two days of last week saw the market open with fairly meaningful gains, only to suffer from selling pressure in late trading. This is a trend that is usually apparent in market corrections but has been largely absent from this current correction. We are encouraged by this action (given our bearish and defensive positioning) and believe this signals further downside in the market. Also, volume on the days where the S&P 500 went lower has been about 5% greater than volume on the up days. The higher bearish intensity as it relates to volume is another indication that the market still has some downside left.

Until the pricing and volume profile improves for the U.S. equity markets, we will remain bearish and defensive.

Sovereign Debt yields

Yields on the Spanish ten year rose above 6% this morning. As of the time of this writing, Italy stands near 5.7%, and France is near 3.1%. All yields are higher for the month. Yields for Germany and the United States have sunk to 1.6% and 1.9%, respectively. All this points to a flight to safety from southern European markets and is very bearish for U.S. stocks.

Figure 5 shows how spikes in southern European yields affected the market last year. Large spikes have brought on tough times for the market. We are seeing similar trends now.

The European debt crisis will remain a dark cloud over the equity markets. We will need to see a return to more normalized yields before taking a bullish stance.

Joseph S. Kalinowski, CFA