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Stay Flexible and Opportunistic

Doug Kass

This commentary originally appeared at 8:35 a.m. EDT on Oct. 11 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

Yesterday I covered all my index hedges and moved back to a 5%-10% net long exposure.

Though this is still quite a defensive posture, it follows a period during which I carried a net short position for a while.

It is important to recognize that I am not a perma-bear nor am I a Cassandra.

There are many ways to skin the market's cat.

Tactical and opportunistic moves are necessary reagents to delivering superior investment returns. Indeed, given the backdrop I see into year-end, trading will be on my front burner, and investing will be demoted to the back burner. So, get ready for more frequent trading (vs. investing) commentary.

I covered my hedges yesterday for several reasons:

  • Yesterday was the fourth day of market losses in a row.
  • Sentiment has turned decidedly negative. Many of those who were optimistic at the market top earlier this month have turned pessimistic. (See Helene Meisler's column.) AAII bears are now at 38.8% vs. 33.2% last week, for the highest reading since mid to late July. AAII bulls are at only 30.6% vs. 33.9% last week, which is the lowest level since August. As Ms. Meisler writes further, the Nasdaq trin was over 1.0 for five days in a row. I expect that many who were bullish at the highs will be bearish in the period ahead. I don't want to be a member of their club.
  • Most importantly, several equities have fallen in price and entered my buy point levels -- for example, Yahoo! YHOO , Bristol-Myers Squibb BMY , Sourcefire FIRE and Fusion-io FIO . Even during corrections, selected stocks can perform well.

I, nevertheless, feel the near-term market outlook is blah and uninspiring. Most market sectors have flaws, and I continue to believe that the tug of war between challenging earnings and the global monetary easing put will be won by the former and that stocks will be headed lower.

  1. Technology: Jim Cramer did an exquisite analysis of the weakening outlook for this sector yesterday afternoon. Among other issues, tech is transitioning from open to closed systems such as Apple AAPL in secular move away from personal computers, AT&T T and Verizon's VZ networks have been built out, the weakening of global economies is hurting consumer spending for tech gadgets, and the move to the cloud is disruptive to technology sales.
  2. Cyclicals: The sector is exposed to a global slowdown, especially in China and Europe.
  3. Financials: These stocks are extended.
  4. Rate-sensitive (utilities, etc.): Names in this space are exposed to the inevitability of higher interest rates.
  5. Staples: These stocks are generally fully valued after a big run.
  6. Transports: Sector share prices have broken down.

My small net long exposure allowed me to be prepared for the market weakness that I saw ahead. Indeed, I shorted small tranches of Financial Select Sector SPDR XLF and SPDR S&P 500 ETF Trust SPY and added to my Goldman Sachs GS short during today's trading, and I am currently about 5% net short.

With so many looking at 1425 for S&P 500 support, I expect that level to hold but only briefly, as I fully anticipate a breach to the downside as it becomes clear how poor third-quarter 2012 earnings are and how weak fourth-quarter and fiscal 2013 guidance will be.

A still likely Democratic presidential win and the impending fiscal cliff remain additional and significant market headwinds.

I view an expansion of P/E multiples as unlikely, so with the earnings outlook murky -- I expect 2013 S&P 500 profits to drop by 3% to 5% -- the market upside is limited.

For now, my fair market value calculation for the S&P remains at 1390, a level that has been in place for months now.

I would not be surprised to see 1390 breached to the downside but not after a failing rally over the next week or so.

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