Author: Clinch Capital
Covestor model: Select Equity
Most investors have heard the famous quote by Warren Buffett: ‘Be fearful when others are greedy and greedy when others are fearful.’ What is the status right now?
The stock market advance since early June has done a lot to buoy investor confidence. This can be seen in – among other factors – the elevated levels of sentiment surveys and low put/call ratios. More recently, the announcement of QE3 by the Fed resulted in a sharp advance in stock prices and pushed the already positive sentiment into what some may call irrational exuberance.
It is this type of overwhelming giddiness that Warren Buffett was referring to when he talked about others being greedy. In my opinion, it is this excessive optimism that will lead to a sharp decline in the stock market in the very near term.
As a matter of fact, the top of the market may already be in place. Take a look at the following chart of the S&P500 Index ETF (SPY):
Source: Freestockcharts.com
The announcement of QE3 on September 13th led to a significant rise in the S&P 500 (as measured here by the SPY) from approximately $144.50 to almost $147.00. The buying continued the next day with SPY advancing to just over $148 a share before reversing the trading lower the rest of the day.
This price action in and of itself is not extremely bearish; however, it is the way we got to these elevated levels (i.e., overwhelmingly bullish consensus) that motivate me to take a short position in the market as of 9/4. (Note: Clinch Capital covered its short of IWM at a loss on 9/18 and went long IWM on that day.)
An added benefit of this price action is that it allows for a relatively low-risk trade that can be quite profitable. We have a clearly defined breakout high in SPY at $148.11. One can short SPY at any level and use that high (or slightly above) as a very definitive stop on the position. Here, you’d be risking about 1% of the position against what I could see being a 5-10% pullback in the market. Those are the types of risk/reward ratios that attract seasoned traders.
Some investments discussed are held in client accounts as of September 24, 2012. These investments may or may not be currently held in client accounts.The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. Covestor believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.
