Good morning traders,

This is somewhat lengthly, but I thought it might be interesting to republish my comments on equities from my morning Waverly Advisors report.  Keep in mind that most of the readers of that report are working on a significantly longer timeframe, but this does help to keep yesterday’s moves in context:

Equities: Equities are in the spotlight this morning.  Let us say, up front and very clearly, that the most important thing is to avoid hitting the panic button and to keep this move in context.  We have had a good run in equities, and we were fortunate to have our clients heavily long for a significant part of the move.  This last trend leg has exceeded our expectations (targets) in terms of both price and time, and the market is overdue for a pullback.  Clients following our trading plan should have been stopped out of no broad index exposure yesterday as our first stops should be somewhere between 1,270 and 1,275 (basis S&P Cash) for index products… Rather than paying attention to the emotions associated with a market move like this, we feel it is important to focus on three questions:  what does this mean for equities in the short-term (1 week)?  What does this mean for equities in the intermediate term (3-6 months), and, perhaps most importantly, how do we manage exposure?

First of all, let’s put this move in context.  In terms of standard deviations, some of yesterday’s moves were quite dramatic, with Microcap indexes selling off nearly 4 standard deviations (3.2%).  (Note that this information is always available on the table in the back of this report.)  Two things to consider are that these standard deviations are somewhat inflated because they use a period of exceptionally low realized vol (the past month) as a reference point, and that the selloff had a clear tilt with  smaller market caps getting hit much harder.  The blue chip Dow Jones Industrials were virtually unchanged at the end of the day (-0.1%, -0.3 standard deviations).  What has happened here is the same thing that happens to market leaders in any context.  Small and micro cap stocks have dramatically outperformed for most of the recent run-up, and are highly overbought by nearly any measure.  It is the nature of market leaders that they get hit first and hardest when the market blinks.   They are sold aggressively for any excuse.  In many ways, this is no different than high momentum market leading names which may sell off 10% – 15% in a few sessions, and then regain the highs within the next few sessions as standard operating procedure.

The key in this scenario is what happens next.  Some downside followthrough is virtually assured after a break from an area of compressed volatility, and first targets have already been reached in overnight markets.  It is also to be expected that world markets will pick up on our weakness, and follow suit for at least a few days.  Our first stops for partial positions (we would recommend these stops be for 40% – 75% of your exposure, depending on your desire to actively manage your risk) will almost certainly be hit, and this is absolutely fine because most of our clients should be holding significant gains at this point.  No sense letting profits melt away under the weight of an overleveraged portfolio in a potentially soft market.  The key is to see how quickly these smaller cap stocks are able to stop the bleeding, recover, and trade back to highs.  It is exceedingly unlikely that this will happen within the next 2-3 sessions; to see the dip bought this quickly would be a sign of incredible underlying strength.

We consider it far more likely that this selloff may have some teeth and may run several weeks, so it is also worth considering how you will manage the remainder of your positions.  In the intermediate term, we maintain our cautiously bullish stance on equities, but we also do not want to be too aggressive in adding exposure back.  You don’t try to catch a falling knife—the correct procedure is to let it stick in the floor, stop vibrating, then pick it up.  We will do our best to find turning points if this selloff continues, but, for now, the correct course of action for most active traders will be to work on reducing and managing existing exposures.  This is a perfectly healthy move in context of a bigger-picture bull market, but we must always respect the downside risk and the possibility of a much larger than expected decline.  Do not get caught without a plan.

• We are coming in this morning to see virtually every major market off fairly significantly.  Asia is down more than a percent, with China broad market down over 3% (2 standard deviations).  Europe is a mixed bag with trouble Spain, Italy and Portugal actually trading higher, while broad European and UK indexes are down a percent or so.  South Pacific stocks were hit very hard, down more than two standard deviations in some major markets.
• In terms of forex, a little pop in the USDCAD catches our attention this morning.  Looking at general Dollar, Euro and Pound strength, and real weakness in AUD and NZD.  Net impact on the US Dollar index (which, remember, is  nearly 60% EUR) is slightly negative to flat this morning.
• No big commodity moves yet, but looking at moderate weakness in metals and Energies, and strength across the board in NYBOT softs.
• Keep the big picture in precious metals in mind.  Big divergence between leaders and laggards in that complex will have to resolve itself one way or another and the complex is overdue for a real move.  Don’t anticipate, but monitor so you can react quickly and appropriately.
• In terms of sector plays, if the market is soft again today there should be good downside plays in some Basic Materials and Financials.  Energy, Industrials and some Tech are holding onto strength a bit better.
• Most of our readers will probably be best served to focus on earnings stocks today, and there are quite a few attractive candidates.  In most circumstances today, it probably does not make sense to focus on sector plays when there will be individual names that should offer exceptional opportunity.

Good trading!