Nov 22, 2007: Road map for a bear

  • Markets overview
  • Roadmap for a bear
  • When MMVR reverses: a look at some short ETFs
  • Markets Overview

    As I write this, SPY (S&P 500 ETF) is up a mere 0.9% for the year.

    This is a pretty remarkable reversal considering that as late as this summer, the S&P500 was up over 20% on a trailing 12-months basis.

    At this point, I have a hunch we've seen a long term top in US markets. Normally, I would wait 2 quarters before calling a major reversal, but I feel in this case the indicators are pretty strong, even though the S&P500 has made an all-time high as recently as this October.

    Why? Let me start with my strongest signal: the broad market leadership shift. Earlier in the year I wrote about the cyclical nature of market leadership, and the fact that small caps have started underperforming large caps after nearly 7 years of out-performance. As long as both asset classes were up, that seemed like a normal leadership rotation. However, shortly after, small-cap value stocks -- as represented by the Russell 2000 value ETF: IWN -- have failed to make new highs despite two market rallies (Early-July and September/October). The point is this: when broad (non-sector) asset-classes go down for so many months and fail to participate in the large-cap rallies - pay attention. A narrowing top lasting ~5 months, is a red light.

    Let's look at the US asset-classes from the leaders to the laggards of the recent bull market:

    So it looks like we have a very orderly (rolling) toppling, where the former leaders give up first, then the runner-ups, and finally the last-man standing. Maybe I shouldn't say "last man": international markets are still way up for the year. Germany (EWG) is up 27.7%, China (FXI) is up 46.7% since January. Here's the main point: if we look back to June 4th, when the old leadership gave up, we are getting pretty close to the 6-month period needed to make the call of a long term top.

    Now, given that the bad mortgages were sold to so many European and Asian financial institutions as structured tranches, I find it hard to believe that this malaise would be confined to the US only. My best bet has to be that it will spread out to the rest of the world.

    Bear markets are painful, not only long-portfolios lose value, investors are also losing precious time waiting for the next bull. The earlier bears can be called, the better. I feel it is my obligation to tell you what I feel is going on. Of course, I could be wrong, the main thing that makes me (slightly) hesitate is that valuations in many cases are reasonable, and that there's a lot of gloom and doom already. You'll have to make your own determination here.

    A few more bearish signals:

    Bear market roadmap and strategy

    I'll try to summarize what I've learned over the years about bear markets. I'll try to describe both: Let me start by saying that bear markets are unavoidable, and that any investor should learn to live with them. If you're a great believer in John Bogle's "timing is futile" mantra, better stop reading now. I'm not going to convince you. My own experience tells me that one can not time the short-term (hourly, daily) moves, but one can time intermediate ones (several weeks to months) to a limited degree, and one can definitely time the major trends and reversals (bull vs bear market). Maybe "time" is not the right word: I think it is very hard to do it ahead of time, but it is possible to call them some time after they have started.

    There are ways to profit in bear markets, and there's no need to get depressed. Even if you lost 10% or so this November, that's not the end of the world, these 10% can be recovered with some discipline, long before the next bull market even starts.

    Now, before anyone goes 100% short or buy puts, I must warn that bear markets tend to have very strong intermediate rallies in them. These rallies can be very confusing and give false hope as if the pain is finally over. The rallies are accentuated by painful short-squeezes forcing the shorts to cover positions. I believe we're now pretty close to the first one.

    Don't rush to sell everything right now, wait for that rally. Also: don't fall into the trap of buying into the coming rally. Instead, use them to lighten up on long positions and getting defensive in anticipation for the next big decline. Read this Ken Fisher column on the anatomy of bubbles bursting (Jan 2001) it is a classic blow-by-blow description of what to expect during bears. On average, you should see 4-5 big ~10% sell-offs with 3-4 intermediate rallies between them.

    Bear markets tend to be shorter than bull markets. Falls are usually sharper. Even the worst bear market in modern history (1929 - 1932) lasted less than 3 years. Much less than the great depression that followed the October 1929 crash. Markets are forward looking and I have no reason to assume this one will be different. The markets should stop making new lows when expectations are so low that earnings can no longer disappoint. This happens roughly 2 quarters before companies start making positive earnings surprises against insanely low expectations. Bear markets typically last roughly between 2 to 6 quarters. A bear market lasting over 2 years (like the 2000-2002 one) is the exception, not the rule.

    Why do I think this one will not be long? Because declines are normally in proportion to the bubbles that precede them. Since we are not starting with the S&P 500 at insane valuations like it was in 2000, I expect the decline to be both smaller, and of shorter duration.

    Earnings in bear markets are very confusing. P/Es tend to skyrocket when earnings (the 'E' in P/E) disappear. During bear markets pay attention to Price/Sales, Price/Book, and Price/Cash-Flow ratios instead. Price/Sales is especially powerful at end of bear markets. Companies with high P/Es and low P/Ss tend to be in the best position to dramatically improve P/Es as earnings start coming back.

    Eventually, many of the biggest losers become the biggest winners. Keep a watch on Financials and Home Builders. There will be a time when they'll be shining again and likely become the biggest stars. That time will come after everyone has relegated them to the garbage bin and no investor wants to touch them. Be patient though. Things should get uglier before everyone throws in the towels.

    Conversely: the biggest winners tend to become the biggest losers. If you made 300% in Brazil since 2003, get out before these gains evaporate. China's fall will be painful, if you are invested in FXI, take your gains, or at least some of them, off the table either now or wait for the coming relief rally.

    The subprime crisis after-effect should be like a very slow train wreck. Subprime borrowers, and those who are still expected to default and be subject to foreclosures are just the tip of the iceberg. A large number of good-credit US homeowners will see their mortgage rates jump higher into 2008 and 2009. This includes anyone who took a 1-year, or 3-year, or 5-year fixed loan, or merely refinanced when interest rates were at ~40-year lows in 2002-2003.

    The San Francisco Bay Area, has been one of the few US metropolitan areas where home prices kept rising in 2007. Don't expect this to last if a recession hits. Virtually all the loans in this area are "Jumbo" loans which now carry significantly higher rates. An increase of just 2% on a 5% APR means 40% increase in monthly payments. This crunch will be very taxing for American consumers and, in turn, for corporate earnings. When the stock market stops making new highs, house prices should decline even in the Bay Area, home of the Googles and Apples. The pain which affects rural America is likely to spread wider just as large-caps should eventually joined small caps on their way down.

    The simplest way to make money in a bear market is to short the markets, but committing most of your cash to a short position is unacceptably risky. I prefer staying defensive (money market, cash) and buying a limited amount of both short and long term puts on assets. The advantage of the shorter term puts is that they are cheaper. The disadvantages are legion:

    If you buy any puts, prefer the longer term ones (several months out) and always buy them when they get cheaper, during the intermediate rallies. Don't buy them right now! Then, after you made a nice small 10-15% profit on near the money puts, get out. Don't hold for too long, reversals tend to hit when fears peak, and when temptation to short the market is the greatest.

    If buying puts makes you uncomfortable, you may buy inverse ETFs. Be careful, the ones that double the inverse returns can be very volatile and more expensive than long term puts. Don't buy those that are up 20% in November, wait till they drop about ~10% in the coming rally before getting into any of them.

    If this all sounds hard for you. Just stay in the money market funds and defensive ETFs (e.g international utilities, international consumer staples, I'm not so sure about energy). You'll earn over 4% on money market funds while you wait, and sleep better while getting ready for the next bull.

    A look at some short ETFs

    This time, there's no MMVR ETF rating. MMVR has been a great bull market ETF picker, but buying cheap ETFs before they get even cheaper is not a good idea. Instead I'm publishing the best return ETFs in the past month, in terms of the percentage increase. These mostly Short ETFs come with a big warning: look at this list and wait. Take it slowly, think it over. Only buy them after the next relief rally. Short ETFs are very dangerous to play with. Whatever you do, even if you're pretty sure the bear market is here to stay, never put all, or even most of your money in them and finally: when you made a little money, be happy with what you've got, get out back into cash, don't play with fire for too long.

    Using ret1m ranking method on 20071121
    1       23.37 SKF     ProShares UltraShort Financials
    2       22.84 SSG     ProShares UltraShort Semiconductors
    3       21.24 SRS     ProShares UltraShort Real Estate
    4       16.73 SDD     ProShares UltraShort SmallCap 600
    5       16.18 SJH     ProShares UltraShort Russell 2000 Value
    6       15.95 TWM     ProShares UltraShort Russell 2000
    7       15.62 SKK     ProShares UltraShort Russell 2000 Growth
    8       15.55 SJF     ProShares UltraShort Russell 1000 Value
    9       14.95 SCC     ProShares UltraShort Consumer Services
    10      14.88 USO     United States Oil
    11      14.87 OIL     iPath Goldman Sachs Crude Oil
    12      14.27 QID     ProShares UltraShort QQQ
    13      13.33 DBO     PowerShares DB Oil
    14      11.88 DBE     PowerShares DB Energy
    15      11.48 MZZ     ProShares UltraShort Mid 400
    16      11.25 SJL     ProShares UltraShort Russell MidCap Value
    17      11.12 INP     iPath MSCI India
    18      11.01 SDK     ProShares UltraShort Russell MidCap Growth
    19       9.89 SIJ     ProShares UltraShort Industrials
    20       9.58 REW     ProShares UltraShort Technology
    21       9.21 UCR     Claymore MACROshares Oil Up Tradeable
    22       8.74 DBC     Db Commodity Index Tracking Fund
    23       8.65 SDS     ProShares UltraShort S&P 500
    24       8.47 GSP     iPath GSCI Total Return Index
    25       8.39 SBB     ProShares Short SmallCap 600
    26       8.38 UPW     ProShares Ultra Utilities
    27       8.12 GSG     iShares GSCI Commodity-Indexed Trust
    28       7.97 RWM     ProShares Short Russell 2000
    29       7.65 DXD     ProShares UltraShort Dow 30
    30       7.47 SLV     iShares Silver Trust
    31       7.36 SFK     ProShares UltraShort Russell 1000 Growth
    32       7.06 SMN     ProShares UltraShort Basic Materials
    33       6.90 DDI     WisdomTree Intl Industrials
    34       6.86 DBS     PowerShares DB Silver
    35       6.45 FXF     CurrencyShares Swiss Franc Trust
    36       6.39 MYY     ProShares Short MidCap 400
    37       6.38 GLD     streetTRACKS Gold Shares
    38       6.34 PSQ     ProShares Short QQQ
    39       6.14 DGL     PowerShares DB Gold
    40       6.12 IAU     iShares COMEX Gold Trust

    As always, I may be totally wrong, make up you own decisions. Any feedback, question, request, criticism etc. is very welcome.

    -- ariel