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Kass: Risks Associated With Second Derivative Rally

The last point merits emphasis, as the presence of unconventional headwinds poses many risks, and since investors have limited experience and historical perspective in dealing with them, it likely ensures a more volatile market backdrop and places limitations to the market's upside potential.

Some of those nontraditional headwinds include the following:
  • the broad geographic reach of the current recession;
  • the increased burden and cost of regulation;
  • the economic impact of the obliterated (but previously important) shadow banking system and the associated reduction in securitized lending market capacity;
  • the more important role of government in the private sector;
  • the possible impact of protectionism and trade barriers;
  • the degree to which individual and institutional investors have become risk-averse and have been "turned off" to equities; and
  • most important, the unusual causes of the current economic downturn and uncertainty of business confidence that follows from the deleveraging of debt on bank and consumer balance sheets.
I am growing increasingly concerned that the same investors/traders that panicked in January to early March are now panicking in the opposite direction in a market that too often worships at the altar of price momentum and that the aforementioned challenges to economic recovery are being ignored.

As seen below, the S&P advance has now eclipsed what was a very optimistic and variant forecast that I presented only two months ago.

SPDR Trust (SPY) -- Expectations
Bloomberg

I prefer to keep emotion out of my investment equation and to be disciplined in buying what I view as undervaluation and in selling what I view as overvaluation.

From my perch, investors' and the media's increasing market enthusiasm (and even downright breathlessness) could be dangerous to one's financial health in the very near term. And a spread of too much optimism is something that could serve to derail the stock market advance.

For the above reasons (and others), I have been recently expanding my short book into the impressive strength, and I have been liquidating extended stocks in the industrial, cyclical and financial groups as well as reducing my exposure to credit, which has had a nice run to the upside. The areas on the short side that I am emphasizing include selected retail and credit card issuers (as the consumer is still in a fragile state), certain financials such as title insurers (higher interest rates pose a threat to refinancings and home turnover) as well as selected technology (in light of a muted capital expenditure cycle). Importantly, shares in these sectors and many of the individual stocks that comprise the groups are all up significantly in price.
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