Nov 22, 2007: Road map for a bear

Highlights:

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:

• Small cap value (IWN), the 7-year asset-class leader of this bull market, rolled-over on June 4th, 2007 (close of $85.10).

• Mid-cap stocks (MDY) were still showing some strength making a run towards the all-time-high point of June 4th: $167.53. Unlike the small-caps which weren't even close, mid-caps almost got there. MDY closed $167.28 on July 19th. That glimmer of hope was gone when MDY failed to come close enough to its high in the recent, very strong September/October rally.

• The 100 largest-cap stocks as represented by the S&P100 ETF (OEF), managed to make a all-time high of $73.12 on October 9th, but that was just a tiny squeak (1.7%) above the $71.93 they hit on July 19th.

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:

• Earnings are weakening. When this starts happening in a broad fashion, I've learned to pay attention. Stock prices always follow earnings. An occasional slight dip in earnings is a common event during bull markets. The big danger is a free-fall in earnings due to the credit and consumer crunch. This is what we seem to have right now. I'll know more after the Q4 earnings announcements. Anyway, the earnings slow-down is not a US only phenomenon. It is now happening all over the world.

• The New York-based Conference Board's monthly forecast of future economic activity -- published on Wednesday, Nov 21st, at 10 a.m. EST -- was a bummer that made the final cut for me. The so called index of leading indicators is made of 10 diverse components:
  1. Average weekly hours worked by manufacturing workers
  2. Average number of initial applications for unemployment insurance
  3. Number of manufacturers' new orders for consumer goods and materials
  4. Speed of delivery of new merchandise to vendors from suppliers
  5. Amount of new orders for capital goods unrelated to defense
  6. Amount of new building permits for residential buildings
  7. The S&P 500 stock index
  8. Inflation-adjusted monetary supply (M2)
  9. Spread between long and short interest rates (the yield curve)
  10. Consumer sentiment

  Caveat: standing alone, the CB's leading indicators index has a tendency to give occasional false alarms (its accuracy now stands at 7 correct recession predictions out of 12 made since 1959), but together with other signals mentioned here, I believe it adds enough weight for a negative direction of the economy for the next 3-6 months. While bear markets sometimes come without recessions, the reverse, as a rule, doesn't happen. A US recession, without a bear market is extremely unlikely.

• The overheating of some emerging economies. China as represented by the iShares FTSE/Xinhua China 25 Index ETF: FXI, is still up almost 75% for the trailing-12 months (and 46.7% for the year), even after a sharp fall of over 25.17% in November (as of Nov 22).

• In November, every short-term rally in the markets, has been met with very powerful selling. There's a huge amount of money trying to get out. Small investors, who can exit all their positions in one day, have a big advantage over the big institutions and the "Billions under management" funds.

• This leads me to Ken Fisher's last column in which he talks about putting some money in Japan in anticipation for a big reversal of the carry-trade. The "carry trade" is going short or borrowing a low-interest currency, like the Japanese Yen, while going long high-interest currencies, like the Euro, and profiting from the spread. Unlike all Fisher's recent memory columns, this column was, surprisingly, not overly-bullish. There was no more talk of the 3rd year of a presidency, a traditionally very good year for stocks, or about the wide earnings-yield spread over treasuries.

  Yes, there was a whiff of bullishness. A surprise: his portfolio looks amazingly like MMVR: quote: "Right now", he writes, "you should be particularly heavy in emerging markets, in Germany, in energy, industrials and materials". But this time the bullishness was muted by talk of hedging and "when eventually trends reverse".

  The carry-trade reversal means no more cheap money to feed stock prices everywhere. It means the Euro losing altitude against the Yen and a strong reversal of the money flow from all over the world equities, back into Japan (closing the carry-trade short positions). My take, and take it for the speculation it is, is that Fisher is in the process of lightening-up, or at least getting more defensive. It takes a lot of time to get out of a $4B portfolio. I'm now on watch for his eventual bear market call. It is interesting that while he was right on, and early on the Tech sector burst in early 2000, he wasn't ready to call a broad bear market until 9 months later. The good news: even being 3 quarters late, still allowed him to avoid most of the last bear market fall and to cement his reputation as a very good long-term market timer.

• Nov 26 Update: the famous "Dow Theory" just signalled the end of the bull: "According to Dow Theory, the bull market ended on July 19, 2007, which was the last time the DJIA and the DJTA both recorded higher closing prices...Therefore, [this] bear market is already four months old." You may read about it on Minyanville. If I'm wrong, I'm definitely not alone now.

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:

• What to expect during bears
• What's the best course of action during bears

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:

• They may expire worthless if you don't get the timing right.

• Getting the timing right is hard:
  • Put buyers are tempted to sit on a temporarily winning position for too long
  • Put buyers tend to buy them after big declines which is the worst time to do so

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