Bear Market or Bull Market Correction?
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Dear Clients:
Following the August credit crunch, stocks rebounded and attempted to challenge all time highs (Dow 14000 & S&P 500 1575). If the indexes had broken above these levels with conviction, I would have expected the stocks to power higher. But they didn’t. Instead the broad markets have retreated over the last couple of weeks. Although this is not conclusive evidence that a more significant correction (or bear market) is imminent, this action is not indicative of a healthy stock market.
The equity markets finished decidedly lower again today. The major indexes closed well below critical technical levels that (13500 on the Dow and 1500 on the S&P 500). The indices are developing a pattern of setting lower lows and lower highs. Lately, down days have been accompanied by higher trading volume and ugly advance/decline statistics, where up days have lacked supportive trading volume and breadth. This action signals further weakness at least in the short term. Today’s breach of these key psychological levels could cause the markets to test the August lows.
Your portfolios had a net (short) equity exposure (10%), a high allocation to cash, and a significant position in 10 year U.S. Treasuries – very enviable shelters when investors are fleeing for safety. The portfolio values should move up slightly. Meanwhile, the Dow and S&P 500 finished lower by 2.6% and 3% respectively. Small cap indices and emerging market indices got hit even harder.
I’ve been waiting for a discernible trend to develop which would indicate a continuation of the bull market or the beginning of a bear market. Right now the preponderance of evidence suggests that the direction is down. This gives me enough confidence to tilt the portfolios a little more short, betting on further weakness in stocks. As such, I added to our short position in the Profunds Ultra Short Mid Cap 400 Index (MZZ). That brings MZZ to a 15% of the overall portfolio. Keep in mind, this fund goes up at 2 times the rate that the Mid Cap index goes down. That’s means you have the equivalent of 30% inverse exposure to the Mid cap index. A 10% long position in the Ishares Russell 1000 Large Cap Growth Index (IWF) offsets/hedges the short position in the MZZ. So, the net short exposure in the overall portfolio is about 20% now. I expect large cap growth stocks to continue to perform better than mid cap stocks, so I think it is a reasonable hedge for the moment.
As a side note, the fact that some instruments like MZZ use half the amount of cash to acquire the desired investment exposure should give you comfort about holding higher than normal cash positions. If you think about it, we can accomplish the same investment objectives and still earn money market rates (currently around 4.5%) on the excess cash. Consider this when you get the feeling that your high cash position is not serving a good purpose.
I think we are at the turning point in the capital markets but major trend changes take time to develop. The effects of the housing recession and the subprime credit crisis are beginning to metastasize in the broader economy. Perhaps investors, at least the sober ones, are beginning to worry about to the creaking noises in the bowels of the ship. I will get more opportunistic with the cash in the portfolios as acquire more clues about the general direction of the markets.
