Kass: Are We Overbought?

On Feb. 17, I presented a watch list of conditions that, if in an improving trend, would likely indicate that a sustainable up move is possible for equities. On March 24, I updated this checklist (and added one more factor) to determine the market's standing. Today, we reevaluate our watch list and issue new grades.

• Bank balance sheets must be recapitalized. The Treasury's public/private partnership has been announced. While time will tell whether the program will be effective in clearing toxic bank assets, it remains my view that the liberalization of mark-to-market accounting coupled with a not-too-stressful bank stress test could reduce or delay the all-important ring-fencing. (I grade the package a B-, down from a B+ a month ago.)
• Bank lending must be restored. Bank lending standards remain tight, and the transmission of credit still remains poor by historic measures. (Grade B, flat with the previous grade.)
• Financial stocks' performance must improve. In the second week of March, financial stocks finally awoke from the dead, and have recently accelerated their move to the upside. Importantly, the emerging strength in the relative and absolute performance in the shares of asset managers such as Franklin Resources (BEN), T. Rowe Price (TROW) and AllianceBernstein (AB), which is typically a forward indicator, has continued. (Grade A, up from B.)
• Commodity prices must rise as a confirmation of worldwide economic growth. Commodities' prices have continued to strengthen, albeit at a decelerating rate. The TIPS market is forecasting about the same level of inflation as 30 days ago. (Grade B-, down from B.)
• Credit spreads and credit availability must improve. Though experiencing some modest improvement, spreads (especially of a junk kind) remain elevated relative to past cycles, and, as mentioned previously, the transmission of credit remains subpar. (Grade C-, up from D.)
• We need evidence of a bottom in the economy, housing markets and housing prices. The retail industry has exhibited evidence of sequential improvement in the January through March period. Real consumer spending in first quarter 2009 was up 1% compared to a nearly 5% drop in 2008's second half. Retail spending (excluding autos) rose by 2% in the first quarter versus a 7%-plus drop in fourth quarter 2008. Other economic signs are somewhat more ambiguous but, nevertheless, are showing some life. Months of inventory of unsold homes are declining and so are mortgage rates, but home prices have yet to stabilize, despite the fact that home ownership is cheap relative to incomes and rental costs. I continue to maintain that the spring home selling season will be better than most anticipate and that housing could surprise to the upside, which might lead most other economic indicators higher. (Grade B, up from C+.)
• We need evidence of more favorable reactions to disappointing earnings and weak guidance. Of all the items on my watch list, this is the best as investors should be encouraged by the near universally better price action in the face of poor earnings results and guidance in a wide range of companies. (Grade A, up from B+.)
• Emerging markets must improve. Non-U.S. markets are joining the worldwide equity celebration. (Grade B+ up from a B.)
• Market volatility must decline. The world's stock markets have settled down and volatility (via the VIX) has subsided slightly. (Grade B, up slightly from C+ four weeks ago.)
• Hedge fund and mutual fund redemptions must ease. I continue to be comfortable in writing that the worst of the redemptions are behind the asset management industry. Nevertheless, the disintermediation and disarray in the hedge fund and fund of fund industries still have a ways to go. And while brokerage account liquidations have moderated coincident with rising share prices, traditional asset manager inflows are still modest. (Grade C+, up from a C.)
• Marginal buyers must emerge. It is clear that the market advance has been fueled by both underinvested individual and institutional investors who are increasingly fearful of being out after a year of being fearful of being in. These two classes could continue to be the near-term marginal buyers fueling stocks. Corporate acquirers have also continued to emerge as important marginal buyers, as evidenced by the pickup in merger and acquisition activity (much in cash vs. stock as deal currency). Should share prices continue to ramp, pension funds, the portfolios of which are skewed towards fixed income, could provide an equity asset allocation catalyst. (Grade B+, up from a B.)
• The market's internals must improve. After experiencing a sequential improvement in sentiment, volume, number of new lows and reduced intensity of the selloff, and after six 90% upside days, the market internals continue to impress. But, after being dramatically oversold in early March, we are now seriously overbought. (Grade C, down from B+.)

In summary, after experiencing close-to-maximum improvement in the rate of change back in late March, the trends in our 12 factors on our watch list are observably decelerating. Arguably, the "wall of worry" has been scaled and the markets have shifted from oversold to overbought now.

As a consequence, I approach today's market with mixed emotions. I would neither sell en masse nor expand equity exposure today. Rather, I would be reducing some exposure, as it seems reasonable that the market will now consolidate its recent gains as we await a move to potentially higher levels during the summer.

My market view, posted six weeks ago in the SPDRs (SPY) chart below, remains precisely on target.

SPDR Trust (SPY) -- Expectations Bloomberg

I would now err on the side of conservatism and increase cash holdings, as, over the near term, I would rather miss opportunity than lose capital. Specifically, I would now expand the cash reserves in my model portfolio by about 10% to 15% by further reducing exposure in industrial cyclicals, financials and credit, all of which have had powerful runs.

Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.

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