There was an interesting pice in Barrons this past week entitled “Expect a Rally as Waders Dive In.”  The basic assumption was that investors who have been sitting on the sidelines over the past three months (or have been participating but with the majority of capital in “safe” investments) may now be forced to throw in the towell and buy despite the difficult economic environment.

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Relying on both technical assumptions as well as a healthy dose of investor psychology, the article does a great job explaining why investors who are skeptical of the economy may commit a hefty amount of capital despite their reservations.  The buying spree could quickly drive markets higher and feed on itself…  at least for a period of time…

In the stock market, the waders might soon be getting in, setting up a new — if only temporary — leg up for stock prices. The jumpers got in first, during the spring, when the water was the coldest and the doom greatest. So far, they’ve been having fun as the waders watched.

At ZachStocks, we could definitely fit the category of jumpers.  Many of our long picks from this spring turned out triple digit gains for investors within months (or even weeks in some cases).  A couple examples include LDK Solar (which we recommended on March 13th), and Verso Paper (from March 25th).

But while fitting the category of “jumpers” at the beginning of the rally, we are also guilty as charged in the “waders” term as our exposure has been paired back in recent weeks.  Our assumption was that employment numbers would continue to be a drag on the economy and weigh down stock prices (particularly retail shares).  It now appears that we could be vulnerable to missing a larger move due to our risk aversion during a tough economic time.

“Deeply oversold, worsening sentiment and positive internal divergences almost always provide the foundation to stock-market recovery,” notes Douglas Kass, a general partner of Seabreeze Partners, an oft-noted bear. Kass, who correctly called the bottom in March and even the June-July pullback, expects some sideways summer action before a liftoff in the early fall — as the waders finally get in — with the Standard & Poor’s 500 index rising to 1025-1050, a double-digit jump.

It is always a bit concerning to find ones self squarely in the middle of popular sentiment.  Investing has a natural bent which favors contrarians, but at the same time being contrary with no logical backup is suicidal.  At the beginning of a large stock move, it is actually beneficial to position yourself in line with the herd so that as more and more people decide to catch the trend, they are buying what you already own.

But the key is offering a contrarian opinion at the end of a trend in order to get out with your winnings before the entire house of cards comes crashing down.  It was our intention to get out of vulnerable equities in late June and early July in order to exit the euphoric trend which appeared to have little economic data backing it up.  But as earnings season has sparked more interest in equities, it now appears we may be vulnerable to missing the second significant move higher.  While I would much rather miss an opportunity to make money, than get stuck in a losing series of trades, there may be some attractive opportunities from a risk/reward standpoint for us to capture a good portion of this next move.

In coming months, Kass says the fear of being out will overcome fear of being in. Kass believes the March low of 666 on the S&P 500 might mark a generational low, but please don’t mistake Kass — or us — for bulls. Huge bull rallies inside bear markets are hardly unusual. The long-term market headwinds haven’t gone away, he notes. In addition to the macro concerns Roque cited, Kass lists an elevated savings rate, which lowers consumption; spreading wage deflation; the devastation of the construction and real-estate industries, once big job creators; and a reduced securitization market, a former growth engine, as factors that will weigh on stocks for years.

So if the next leg up really is in force, there will be opportunities, but they will most likely be outside of retail stocks which are affected by consumer spending / savings rates, employment statistics, and other sentiment gauges.  Investments in commodity and trading sensitive stocks may give us the best bang for our buck, including sotcks like Potash Corp, Blackstone Group, and ReneSola.  Retail stocks may still make for good short positions, but the opportunity may have to wait for a few weeks or months as investor sentiment continues to evolve.  In the end, investors who are willing to be flexible and open minded will likely collect the largest portion of available gains in this volatile year.

FD: Author has a long position in BX, and LDK in the ZachStocks Growth Model

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