Repositioning Before the Coming Selloff

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Yesterday morning, I warned clients to use any lift to sell equities. CNBC reported on the call in the afternoon, and many readers have asked for a more detailed explanation.

Last week the market became so oversold that a corrective bounce was due. We saw that move begin in Monday's rally. But don't get too excited yet: I expect this bounce to last a week or so -- two at most -- before the markets start heading south again in a selloff that I expect to last until early summer, and bring the Dow down to the 8,800 to 9,000 level.

As such, I have been advising clients to use any lift as an opportunity to exit most of their long positions. In particular, I have been exhorting managers to sell cyclical, rate-sensitive and high-beta holdings.

I have aggressively sold equities, and I am now about 50% cash. I expect to be in even more cash by next week. If some of the major oils come down enough, I will selectively add to those positions. I'd like to see Interoil (IOC Quote) at $32-$34 prior to re-entry. I'm also looking for an advantageous entry into gold, including the ETF/Gold Trust(GLD Quote) -- anywhere between $40-$43. Finally, I am looking for the recent rate rally to sputter out. I am considering buying the iShares Lehman 20-Year-Plus Treasury Bond Fund(TLT Quote). An entry between $84-$88 is technically warranted, and yields 4.6%. It's as good a place to hide as any.

Individual investors should also take advantage of any better prices to aggressively sell positions that meet those qualifications. I'd also dump individual stocks that have not been behaving well. And as I wrote last week, it is crucial for individual investors to eliminate long margin exposure.

Down near 8800-9000, I would become a buyer again, depending upon circumstances and conditions at that time.

Don't Fight the Rally

Several factors point to a modest but short-lived rally.

From a sentiment perspective, the bulls have gotten scared. AAII now shows bulls at 23%, down from 45% two weeks ago; bears measure 41.9%, a big move up from 24.8% over the same time period. That's simply too bearish, short term.

Other measures also suggest that the market has reached a moderately oversold level. The NYSE oversold indicator, where any reading below -50 is significant, measured 58.12; So too, the NYSE McClellan oscillator reads oversold at -256; anything below -200 is significant there.

Despite all these oversold signals, I remain concerned about the ongoing deterioration in both the internals and the macro environment. The advance/decline Line continues to soften, something that should not be occurring as the market rallies, and the Nasdaq 52-week highs/lows (See chart) also has flipped negative.

High/Low Flips Negative This is another sign of deteriorating technicals

Click here for larger image.

Source: Maxim Group, Barry Ritholtz

Longer-term trendlines also have broken and upside moves have been unable to sustain their gains. This is a clear sign that momentum is fading.

The Economic Environment Is Weakening

Now add problems in the macroeconomic environment to the technical deterioration. GDP has softened.

Personal income is not keeping up with price increases, just as consumers have lost the ability to do cash-out refinanced mortgages. (If you are looking for a reason as to why mutual fund flows have been so light, that's as good as any.) Money supply has also been throttled back by the Fed, and the yield curve is flattening.

We now have an oversold market that has not been able to rally on positive news. This reveals an underlying weakness, and possibly a decreasing appetite for equities. The market's complete inability to respond well to the major upside revision from General Electric(GE Quote) last week suggests a market lacking leadership.