Cue The Fat Lady

Wednesday, May 24, 2006 | 11:34 AM

How is it that very important issues are all but ignored by the markets for seemingly forever, and then all of a sudden they start to matter a great deal? Why is that?

Its a quandary facing disillusioned investors. They are perplexed: A series of risk factors which have long been staring investors in the face are suddenly getting a lot more weighting than they had been. Call it reality’s revenge.

I suspect a large part of the problem is the market’s illusion of efficiency. Perhaps over the long run – you know, the long run in which we are all dead – the market is mostly kinda efficient. But over the short run, it is quite apparent that markets are hardly very efficient at all. And has been famously observed, their capacity for staying irrational is far greater than your capacity for staying solvent. Hence, the importance on waiting for clear signals to short tops and buy bottoms, rather than merely guessing.

That’s where we now find ourselves. The four year Bull market which traces its start to the September 2002 lows and pre-war March 2003 retest is now getting quite tired. We see continued warning signals that it is running out of fuel. As the technical signals accumulate, a plethora of risk factors are coming home to roost (all bird flu puns aside).

Since investing is all about getting paid for taking risk, it behooves us to understand when it is more or less rewarding to assume that peril. John Hussman astutely observes that “risk tends to be unusually rewarding when market valuations are low and interest rates are falling.” The opposite is also true: “Market risk tends to be poorly rewarded when market valuations are rich and interest rates are rising.” Long term investing success comes from correctly identifying which of these ecosystems we are in.

Hence, all the recent turmoil. I suspect we are now in a transition period, where the ability of the masses to deny what a few have recognized can no longer be sustained. Our collective capacity for self-delusion is great, and markets are merely a collection of Humans. Eventually, the market – us imperfect Humans – start to recognize what has been staring us in the face the whole time. We adjust our holdings, reduce risk, and shift assets accordingly. That process is now well underway.

Its worth watching the leadership of the bounce (whenever it finally gets here). Look to see if the traditional safe harbors outperform: watch defensive plays, like Bonds, Utilities, Big Caps, even Food and Beer stocks. As the reality of this aging Bull settles in risk appetite will shrink.

Look for a run up towards recent highs – that’s where your shorting opportunity will be. As too few traders really know, Patience is called for. We expect it will be rewarded.


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UPDATE: May 27, 2006 9:28am

I just noticed that swingtrader and author Alan Farley is also looking for a run back towards the highs this summer:

Summer Rally?   5/26/2006 4:17 PM EDT

Folks pounding the tables about lower prices ahead might want to take a look at the weekly closing bars on the SP-500, Nasdaq Composite and Nasdaq-100. They are very bullish and even suggest that a test of the 2006 highs may on the agenda this summer. Go figure.

Good company. As mentioned, Farley was one of the few who avoided the falling knife catching fever.

Wednesday, May 24, 2006 | 11:34 AM | Permalink | Comments (28) | TrackBack (1)
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» Reality Bites from Bear Mountain Bull
Barry Ritholtz at The Big Picture wonders why, all of a sudden, the risks that many of us have known were out there have started to matter to the markets: How is it that very important issues are all but ignored by the markets for seemingly forever, an... [Read More]

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Comments

I believe many market participants fully recognized the risks they were taking. Partly due to pressures to put up good performance numbers, but mostly due to arrogance and huge egos, most of those people felt they could exit unscathed, or nearly so, once they sensed the top.

The market has an amazing way of humbling people.

Posted by: S | May 24, 2006 12:30:36 PM

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