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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