Nov 30, 2007: a bearish portfolio

  • Market overview
  • Perspective from an iShares prospectus
  • A zero-correlated bearish portfolio
  • Market Overview

    In my previous column, I wrote about the tell-tell signs of a long term top in the broad US indexes, the world-wide slow-down in earnings and more indicators leading me to believe we are now in the beginning stages of a bear market.

    Since that article was published several more confirmations have occurred, notably:

    As expected, we had a relief rally last week. That was a golden opportunity, if you're bearish of course, to lighten up on equities and possibly to put a toe or two into market puts. As of this Monday it is not too late to do so. If you get money out of stocks, be wary of "money market" funds. It is not clear what percentage of these "money market" funds is invested in SIVs. Ask your broker, double check their response, and consider the portfolio detailed below.

    Perspective from a iShares prospectus

    This weekend I received an electronic prospectus from Barclays Global Investors (BGI) iShares. BGI are the biggest ETF issuer. The summary pages were an eye opener. I enclose the Russell 1000 one, for a quick 7 year perspective.

    The iShares Russell 1000 (US large cap) and Russell 2000 (US small cap) index ETFs inception date was shortly after a bubble top in US markets, they started trading in May 2000. The tech and dot-com bubble of the late 90's was one of the biggest bubbles of the "large-cap growth" asset-class.

    As you can see from the summary, one of those ETFs (Russell 1000, Growth) is still a whopping 17.58% in the red, over 7 years later, for those who bought it close to that top.

    The lesson is two fold:

    Is there a half-full glass here? The current US market is nowhere near what it was in 2000 in terms of valuation, that's the good news. Don't miss the half-empty side either: when earnings vanish, P/E ratios skyrocket.

    All the above leaves open the question what will happen with the rest of the world. Indeed, some countries have pretty low valuations. But again, P/Es are a very tenuous creature once a recession hits.

    Anyway, at this point I feel it is significantly safer to bet on a US downturn that it is to bet on a continuing increase of stock prices worldwide. I've yet to see a case where the leading economy of the world tanks, while the rest of the world continues on its merry way.

    A bearish zero-correlation model portfolio

    I'll conclude with a 8-ETF model portfolio for hard times I came up with about a week ago with some small modifications I made a week later. It is based on the following:

    If you don't feel comfortable with the doubly leveraged inverse ETFs (Ultrashort), you may underweight the short portion of this portfolio or not put anything in the Ultrashort ETFs.

    What to expect:

    So, I won't be surprised, and won't be worried at all, if this portfolio loses 2%-4% on a day where the fed lowers interest rates, or another grand scheme to save the subprime market is announced. Such days should not be considered as invalidation to the bear thesis, but instead, as an opportunity to get into these bearish positions.

    I recommend starting with the longs first, and only then, gradually add the shorts, especially on days of great euphoria when the S&P 500 is up over 1%.

    Backtesting on November 1st to November 30
    Note 1: This is too optimistic, since November has been great for bears
    Note 2: I switched a two WisdomTree long ETFs to slightly better
    	(lower-valuations, lower expenses, less volatile) alternatives
    	while keeping the holdings in the same ideas/sectors.
    Portfolio[8]:   SDS TWM SRS IHF KXI DBA JXI IXC
    %Change[20]:    1.15 0.68 0.06 1.23 0.36 0.42 -0.50 -1.64 0.66 0.05 1.47
    		1.11 1.04 0.70 -0.84 1.88 -0.75 -2.10 0.21 -0.84
    Correlation matrix [2007-11-01..2007-11-30/1d]:
           SDS  TWM  SRS  IHF  KXI  DBA  JXI  IXC
    SDS      -  .97  .84 -.66 -.92 -.46 -.72 -.73
    TWM    .97    -  .85 -.65 -.89 -.49 -.71 -.70
    SRS    .84  .85    - -.54 -.65 -.22 -.45 -.39
    IHF   -.66 -.65 -.54    -  .65  .36  .53  .50
    KXI   -.92 -.89 -.65  .65    -  .46  .87  .81
    DBA   -.46 -.49 -.22  .36  .46    -  .56  .72
    JXI   -.72 -.71 -.45  .53  .87  .56    -  .86
    IXC   -.73 -.70 -.39  .50  .81  .72  .86    -
    					Mean correlation: -0.007897
    [2007-11-01-2007-11-30/1d 8]    Portfolio        SPY    Portfolio-vs-SPY
    (better: > 1.0)
    ----------------------------    ---------       ------  ----------------
    %Total_Return:                       4.32        -1.57              +INF
    %Annualized:                        70.38       -18.07              +INF
    %Return_Mean:                        0.21        -0.08              +INF
    %Return_StdDev:                      1.03         1.61              1.56
    %Volatility:                        16.36        25.58              1.56
    %Max_DrawDown:                      -2.10        -2.74              1.30
    Omicron:                           1.6289       0.8858              1.84
    Omega:                             1.8348       0.3937              4.66
    Omega/Omicron:                     1.1264       0.4445              2.53
    %Alpha(annual):                     59.18         0.00                 -
    Beta:                               -0.49         1.00              2.05
    Alpha/Beta:                        121.41         0.00                 -
    R(correlation):                     -0.76         1.00              1.31
    %R2:                                58.13       100.00              1.72
    Sharpe_ratio:                      0.2054      -0.0491              +INF
    Sortino_ratio:                     0.2100      -0.0782              +INF
    Longs (in rough order of attractiveness):
    DBA     PowerShares DB Agriculture
    IHF     iShares Dow Jones US Healthcare Provider
    JXI     iShares S&P Global Utilities
    IXC     iShares S&P Global Energy Sector
    KXI     iShares S&P Global Consumer Staples
    Shorts (in rough order of attractiveness):
    SRS     ProShares UltraShort Real Estate
    TWM     ProShares UltraShort Russell 2000
    SDS     ProShares UltraShort S&P 500

    As always, every investor should make up their own decisions. Any feedback, question, request, criticism etc. is very welcome.

    -- ariel