Hedge Funds are in charge of the Rotational Market

NOTE:  This Maarket Commentary alert was originally emailed to subscribers at Ritholtz Research & Analytics on Mon 10/16/2006 12:08 PM EDT;

This is posted here not as investing advice, but
rather as an example of a trading call for potential subscribers. We
expect to post future advisories in a similar manner — after the call,
but in the correct chronological location on the blog.

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We have a longer piece coming out later on the markets and the macro Environment, but I wanted to get a short note out today about some crucial issues ahead of us.

Before my parade of horribles, let me give you a half dozen positives:

- The Technical situation has become much more constructive;
- Sentiment, while Bullish, hasn’t crossed over to extremes (yet);
- Money Flow has seen some more cash head to domestic Equities;
- Option expiration can have a positive influence on equities;
- Commitment of Traders (COTC) are record long the SPX;
- Alpha (performance) chasing hedge funds are in charge of the short term.

These elements are the primary reason we are not short.

With these positives, why would we even want to think about selling, much less getting short? It’s due to the “disconnect” between reality and the markets – its now widening. The negatives are piling up so fast, it’s all we can do to keep up with them.

Two recent studies drew our attention:  First, we note that Chief Financial Officers’ optimism about the U.S. economy has sunk to a 5 year low, according to a study by Duke University. Because of this, many are planning for reductions in capital spending and hiring.

You may be tempted to write off this negativity as the ordinary gloom of the green-visored number-crunchers. Hey, the bean-counters are always unhappy with  spending anyway. We are better off looking at what the CEO’s– a generally chipper group by nature – have to say about the future. They tend to be much more upbeat.

Uh-oh.  A recent survey finds that Chief Executive Officers has seen their confidence levels sink to five-year lows also. For the first time since the last quarter of 2001, gloomy responses from the big bosses outnumber cheerful ones. This according to (of all groups) the Conference Board, an outfit known for their cheerleading tendencies.

Given that the people in charge of spending and hiring plan on doing very little of each, one might think the stock market might be a bit more circumspect. No such luck.

The COTC – the so called smart money – are at record setting long exposure. That suggests that there is still more upside ahead. My best guess is through the election. But given how crowded the long side trade now is, risk remains high, with a low relative reward. As this plays out, a sudden correction remains a dangerously high probability event.

I’ll have more details, along with the academic studies that predicted the speculative echo, later this week.

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