Classic Bear Market

Equities have been in a classic bear market the past 6-8 weeks. Sometimes jumping higher, investors constantly waiting for a bounce, but prices gradually moving down, down, down. It is amazing that SPX is down about 200 points from its recent peak and still there have not been any days with drops of 3% or more. On the contrary, whenever the market does drop a lot intra-day, it usually recovers some or all of the drop by the close, just to keep people in the game. There have also been lots of the classic bear market pattern of higher opens and lower closes.

Performance last week was good; portfolio gained 2.7% vs. losses of about 2% on both SPX and the S&P/TSX indices. However, the portfolio has still not re-gained its level before the March lows. Looking at some past trades, the decision to clear my long gold position my probably correct but clearly poorly timed -- gold shares have since rallied nicely. I am happy with the short energy position and may add to it on a pull-back. The short real estate position has finally recovered to close to the purchase price, and should do well from here.

Economic news was pretty light this week. Initial claims pulled back but the previous week was a holiday and the non-seasonally adjusted number was about 400k. The trade balance improved, which some people saw as a positive but is pretty negative from my perspective -- weak imports mean weak domestic demand and lower exports from the rest of the world. Consumer sentiment was more or less unchanged at very depressed levels. The decision by the regulators to close Indymac will certainly have repercussions for the US housing market, given that the company was the 3rd largest mortgage company in the country.

In other parts of the world, the BOE remained on hold despite an economy that appears to be on the verge of recession. Note that sterling and euro yield curves are very slightly inverted at the 1Y/10Y levels, indicating a high probability of recession. China export growth is decelerating, which should be no surprise given slowing demand in the major developed economies. The Japanese economy has also been producing some weak figures, but I think that the return of -inflation there should mean higher asset prices over the medium-term (a good trade to consider after global equity prices fall a bit more).

I have been short equities for a while now, and my faith that the market was always going down did not waver much -- until now. This is for a number of reasons: 1) Sentiment is starting to get pretty negative. It seems everyone and their dog is a bear now. The news on the economy is getting bad, and a recession is starting to become widely accepted (again). Those people who think the market may go up are only talking about a short-term bounce. 2) short interest is very high by historical standards (though this is not as objective a measure as it appears on the surface). 3) the market has been oversold for a while. In addition, there might be a post-Indymac bounce just as there was a post Bear bounce in March, plus there is the rumour of the Treasury injecting funds into Fannie and Freddie Monday morning that should alleviate concerns there for the short-term anyways.

On the flipside, there has still not been a real capitulation. No large down days in equities, JPY/EUR is strong at 169, and the 2-year US bill closed on Friday at 2.58, hardly indicating fear (although treasuries were supposedly weak due to concerns that the government would have to take on the GSE's liabilities -- these seems extreme). VIX has remained comfortably low, again closing well below 30 (although this signal's value may have declined significantly since everyone appears to be watching it to time a bottom -- e.g. Bloomberg story last week). Finally, valuations are still much too high. As I mentioned last week, SPX aggregate earnings are probably about $70 right now. Assume a typical market bottoming p/e of 12 or even 14 would put the index in the 840-980 range.



What is needed is a steep enough decline to bring valuations and expectations down and also knock oil off its pedastal. This would probably set-up a nice rally that could last for 3-6 months, if not longer. Although a bottom in August in September still seems the most likely scenario, there is the possibility of a major decline in the next few days given the recent events. I plan to watch the price action closely to try an anticipate if it is worth taking some money off the table, if only for a short period.


MARKET POSITION: EQUITIES - short SPX (5 units); short S&P/TSX (5 units); short EAFE (3.5 units); short energy (1 unit); short real estate (2 units); CASH (1 unit)