Nov 30, 2007: a bearish portfolio

Highlights:

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:

• The S&P 500 earnings picture is getting uglier by the day. "Bloomberg reports U.S. corporate profits are in a recession with some predicting an economic recession is not far behind. Corporate profits as measured by the Commerce Department fell at an annual rate of $19.3 bln in 3Q from 2Q. Further, earnings from companies in the S&P 500 fell almost 25% (the largest annual decline in over five years) as companies reduce spending and hiring due to slower sales and higher energy and labor costs."

• The Pollyannas would say that this is because of the huge one-time write-offs in the financial sector, to which I would respond that it is highly unlikely that the write-offs are over yet. Indeed: "Moody's late Friday said ratings may be cut in $105 billion of debt sold by structured investment vehicles (SIV's) after the net asset values of 20 SIVs sponsored by firms such as Citigroup (C) declined to 55% from 71% a month ago" [Source: Moody's, according to Bloomberg.]

• SIVs had about $320 billion of assets as recently as October, according to the ratings companies. How much of this value will have to be marked down no one seems to know yet. What we do know for sure is that as long as Moody's keeps writing those down, depressed corporate earnings should inevitably follow. When this happens, the broad indexes will follow, on the way down.

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:

• Don't enter the market after a prolonged bull, especially if stock valuation makes it obvious that they are a bad deal. In 2000, it was dot-com stocks. In 2007 FXI, the China 25 ETF, comes to mind.

• Even if you made a mistake, and got in near a top, all is not lost. Bear markets take many months to develop. Beware the Siren song of the "Buy and Hold" coming from the same institutions who dump their holdings while supporting the same assets with your bi-weekly 401(k) money. As a small investor you have an enormous advantage over the institutions when it comes to moving decisively and fast.

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:

• Attempts to avoid the money market trap (may be exposed to SIV's)

• Attempts to minimize correlation and hedge against a rise in the markets by being long on select sectors. This portfolio has a near zero mean correlation (within itself) based on the 20 trading days: November 1st - November 30.

• Is overall bearish with some significant leverage on the short side.

• Assumes that the worst may be over for some sectors (like home builders and financials) so tries to go short those I feel has a way to fall still.

• Gives significant international weight to the long part of the portfolio.

• Attempts to be much less volatile (beta) than the index, while having a higher alpha.

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:

• When markets go up a lot, this portfolio should go down
• When markets go up a little, this portfolio should be down a little bit
• When markets go down a little, this portfolio should be up
• When markets go down a lot, this portfolio should be up even more

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