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Defying Gravity

 October 31, 2011 09:58 AM

Something has changed within me
Something is not the same
I'm through with playing by the rules
Of someone else's game

Too late for second-guessing
Too late to go back to sleep
It's time to trust my instincts
Close my eyes: and leap!

It's time to try defying gravity
I think I'll try defying gravity
And you can't pull me down!

- Defying Gravity lyrics, from Wicked

The rally in risky assets in reaction to the EU Grand Rescue Plan was awesome to behold as the risky assets seemed to defy gravity despite grave concerns expressed by analysts over the details of the plan. The rally has unleashed a tsuanmi of positive price momentum. However, medium term concerns from cyclical indicators, measures of risk aversion and macro concerns over the sustainability of the eurozone "fix" leaves me to believe that we are undergoing a consolidation phase with an upward bias in the next few months.

I would be inclined to become more cautious about the outlook for equities and other risky assets in the 1Q and 2Q of 2012. My Inflation-Deflation Timer Model agrees with this assessment and has moved to a "neutral" from a "deflation" reading, which would orient the model portfolio from a bond heavy tilt to a more balanced weighting between stocks and bonds.

In the meantime, enjoy the spectacle of stocks defying macro-risk gravity.

Powerful momentum
To see how powerful the momentum is, you just have to look at the chart of the SPX. It shows that the index not only rallied through a downtrend line, but through resistance at the 1260 level and the 200 day moving average. Does this mean that the tide has turned and it's now up, up and away from now on?

Charts from a number of major equity averages around the world seem to suggest that bullish view. The FTSE 100 shows a similar pattern of a rally to test the 200 day moving average.

Even the Euro STOXX 50 shows a pattern of a turnaround. It broke through a downtrend line and the index is now in a minor uptrend, though the rally hasn't quite reached the 200 day moving average yet.

Moving eastward, even the Hang Seng Index has shown a pattern of strength by rallying through an important multi-year resistance zone.

Cyclical red flags
While the short-term momentum has been impressive, cyclical indicators are not sounding the all clear signal just yet. The resource-heavy and cyclically oriented Canadian equity market is showing a pattern of a rally through a short-term downtrend, but the longer term downtrend remains intact.

Commodities are also telling a similar story of a counter-trend rally within a longer term downtrend.

The Shanghai Composite isn't looking as healthy as Hong Kong or the other major equity averages around the world as it is struggling at the site of the 50 day moving average as well as a major resistance zone.

Inter-market analysis confirms my cyclical concerns. The relative performance of the Morgan Stanley Cyclical Index against the market also shows a pattern of a counter-trend rally within the context of a longer term relative downtrend.

Risk appetite returns, but...
Measures of risk appetite are also telling a similar story of a retracement within a longer term downtrend. Consider, for example, the performance of the NASDAQ Composite against the large cap NASDAQ 100. The ratio rallied through a relative downtrend line, but it has barely retraced much of the technical damage done when the risk aversion trade began in July. This chart suggest to me that the current rally has further to go, but a more realistic expectation would be a period of sideways consolidation with an upward bias.

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