Hedging some bets

Last week was a good one. Despite the fact that SPX rose fairly strongly, and I have a strong bearish bias in my positions, my portfolio rose in value, reaching its highest point since early March. With this in mind, and with SPX moving higher again in early trading today, I thought it might be a good idea to hedge some bets. The primary reason for my good performance the past few weeks has been the fall in energy and commodity stocks (I am short both the S&P/TSX index, which is heavily weighted towards commodity plays, and the S&P/TSX energy index).

Looking around for a cheap hedge, gold stocks seemed like a good candidate. The price of gold has fallen by about $150 over the past month or so, and gold stocks have been crushed. HGU, the Canadian ETF that tracks gold stocks, has declined by almost 50% since July 14. I previously owned HGU earlier this year, but sold my positions at levels about 50% higher than here (which was tough at the time, as it then went up about 25%, but I feel vindicated now). Although I am usually wary of trying to "catch a falling knife", a small gold position seems like a good way to offset some of the risk that my short S&P/TSX and energy positions might turn around after strong runs. Enhanced risk management is also part of my new strategy. I reduced S&P/TSX to partially fund the purchase, raising a bit of cash in the process.

MARKET POSITION: EQUITIES - short SPX (5 units); short S&P/TSX (3 units); short EAFE (3.5 units); short energy (2 units); short real estate (2 units) ; long gold (2 units)

Summer Doldrums

After my best month yet (June), I managed to follow-up with second positive month, making 2 consecutive positive months for the first time. This fact, plus that my portfolio is barely even 12 months after starting this journal may indicate that risk management has not played as strong a role as it should have (although many have done much worse, I suppose). So I plan to try to have a greater emphasis on risk management this year. This will mean more stop losses to ditch losing trades, more closing out of positions when the risk-adjusted return wanes, a greater attempt to find trades where some of the risk is offset, and higher cash holdings in times of uncertainty.

Economic news last week continued to be poor, though not terrible. Internationally, there is growing fear of recession in the UK, some smaller eurozone countries and Japan, and the economies of Germany, Canada, Australia and India appear to be slowing. Even the Chinese are now more worried about growth than inflation. In the US, the initial unemployment claims hit almost 450k, a level consistent with a recession. Q2 GDP numbers were lower than expected and Q4-07 was revised to negative. ISM came in at 50, though the forward-looking components were weak. The employment report was viewed as positive because jobs declined by 'only' 50k or so. The Baltic Dry index is down.

On to the markets: bond yields are rangebound, though down from their peak several weeks ago. Nothing really interesting in the FX markets. Commercial paper spreads remain wide, as is LIBOR. Mortgage rates are about the same as they were 12 months ago before the credit crisis even started and the Fed funds rate was much higher (not good for the housing market). Commodities prices are weak. Oil is $20 off its highs, as are many industrial metals.

The rally in equities may have petered out. There was a failed attempt by SPX to break above the 1290ish mark set 2 weeks ago. This is negative as bear market rallies need to maintain momentum, otherwise they die. I took a quick look at most of the rallies following sharp declines over the past 5 years or so (using SPX). I did not see one where the rally stalled for longer than 5-6 days. Pull-backs were always very short. There is nothing scientific in this, but it suggests that we may not be seeing 1325 anytime soon as many pundits are suggesting. Many people see April-May as the model for the current rally -- a gradual move higher over 2 months or so. The market rarely repeats itself so cleanly.

I continue to believe that we will see a major market bottom in the near future, either this month or early next. This may be followed by a brief rally and a re-test of the lows, and then a sustainable rally for a considerable period. One can then assess whether the global economy is out of the woods, or if their is scope for further declines. As there have not been any changes in my strategy, there have been no changes to my portfolio.

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

Waiting again

After some excitement last week, it is back to waiting again. Waiting for the markets to finally collapse. Last Tuesday there was a brief moment when it looked like it might happen, but then the markets pulled back from the brink and rallied fairly hard the next 2 days. Despite my concern that a bounce was near, I elected not to cover my shorts. I had set a few indicators that I wanted to see before I covered (sharp falls in 2 yr note yield and EUR/JPY, VIX above 32/33, SPX near 1100). And although all of them started to move in the right direction on Tuesday, they were never close to what I was looking for. This shows that there was relatively little panic amongst institutional investors, suggesting that the bottom is yet to come. I mentioned a few weeks ago that I thought the bottom would come in August or September, I am going to stick with that for now.

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

Strange

More of the same in equities today: open higher, grind lower through the day, and another new low at the close. What I find strange is how little volatility there was (relatively speaking). With the Indymac and GSE announcements, I expected either a strong rally or a collapse. Difficult to see this trend going on for much longer -- it seems that everyone is bearish (especially on financials). Either there needs to be a bounce to clear the oversold condition, or there needs to be a collapse to bring valuations to a more reasonable level.

Although I am increasingly uncomfortable with my short index position, I am not going to cover unless there are either some signs of capitulation or valuations get to a more reasonable level (say, below 1100 on SPX). I also took advantage of the strength in energy equities today to add one unit to my short energy position. As mentioned before, it seems that the price of oil is now squeezing the global economy so badly that demand is suffering, so the price should decline soon. However, if it does go higher still, the position is well hedged against my short index positions, as an even higher oil price would put severe downward pressure on global equity markets.

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

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)

Performance to 4 July 2008

Quick post. On performance, June was my best month so far, but this was off a terrible April/May, so does not account for much.

On the markets: equities globally are down, a lot in most cases. Many people are calling for a bounce here, based on three factors: the markets are very oversold, markets have touched a few important technical lines (e.g. the Jan/March lows on SPX), and general sentiment seems to be getting pretty bearish again as investors realise that the US probably has NOT escaped a recession.

I agree with all of these points, yet I still do not see the conditions necessary for a sustainable move upwards. For me, the most important indicators are those that point to a high level of concern or panic, and I do not see that yet. Vix is still in the mid-20s, the Yen is softish, there has yet to be a 3%+ down day nor a large downside gap at the open.

I remember the old trader's maxim: do not sell a stock just because it has gone up. I also remember that over the past 6 months, there has been many times that the market looked like it was very overbought, and then it went higher still. I also remember that in bear markets, the last few days/weeks can account for over half of the fall in prices.

The combination of factors weighing on this market are very strong: housing crash, credit crunch (which spreads indicate is still with us), a weakening economy (unemployment up 1.1 pp over the past year), and ridiculous oil prices ($140+ last week). And valuations are not reflecting this. The P/E on SPX is currently a little over 17. Given the poor earnings outlook + bouyant (if not rising) inflation, the p/e should probably be more like 14, if not 12. I remain short.

There has been no change in my positions but I have re-tooled the weightings to reflect changes in market valuations.

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)

Orderly slide

This recent slide in the equity markets has been perfect. Fairly steep, but orderly, gradual. No large gaps or sudden slides. I suspect this is because many participants are a bit shell-shocked. They thought that the economy avoided a recession, or they thought that it was going to be short and shallow, and therefore the bottom in the market was already in.

There is a large and growing bear contingent on the web, and this worries me a bit. But many of them were talking about a bounce last Friday, and it never came, so maybe they were as surprised as everyone else by the markets over the past 2 days.

I think that as long as the decline remains fairly orderly and VIX stays at reasonable levels (say, below 32/33), we could have an acceleration of the decline over the next few weeks. I am looking for about 1100 on SPX. And if concerns about global growth continue to rise, then commodities should fall, and the TSX could fall pretty hard and fast with them. I am going to watch VIX for a sign to cover, plus for a large downside gap on the open.

MARKET POSITION: SHORT EQUITIES (10 units); SHORT REAL ESTATE (3 units); SHORT ENERGY (1 unit)