Monday, September 21, 2009

Cyclical Bull in a Long Term Bear Market/ Hedging

I am going to be occupied with other matters today.

1. Hedging: Most of the time, I hedge by selling the asset class that I view as in need of a hedge. That is based on my simpleton view that the best hedge comes from selling the long position until I reach a comfort level. A recent example was selling down by stock positions into the current rally, just a tad, but I also started last week a small hedge.

There are several ways that I can hedge a stock or bond portfolio. I have discussed extensively my use of the double short ETFs last year to hedge my stock portfolio, relying primarily on two of them-TWM and SDS. As some readers have noted there are tracking issues involved with these double short ETFs. I would never buy one of those ETFs to bet on the directional move, but simply as a temporary partial hedge for a long position. Last year, I used the VIX movement as a timing mechanism to buy and sell the double shorts, buing them on a move below 20 in the VIX and selling them on a spurt above 30, a process that broke down after the Lehman failure. Some of my earlier discussions are contained in these posts:

These posts discuss some of the tracking errors:

I also used TBT and PST earlier in the year to hedge a long corporate bond portfolio, and have sold both of those positions.

After selling some of what I view as in need of a hedge, there are a number of ways to hedge. Some individuals would prefer buying options, to hedge individual security positions by selling calls or by buying puts on an index. Some may sell short an Index ETF like SPY for the S & P 500 or IWM for the Russell 2000 or TLT for 20 year treasury bonds.

I would say that most of my response is just to sell long positions. Occasionally I will put on a small hedge with the doubt short ETFs, and that is just a matter of personal preference.

I have currently restarted a small position in a double short ETF last week for stocks.

I am evaluating buying at some point before the end of the year a small hedge position on bonds. One way that I hedge my bond position is to reduce my fixed coupon bonds and increase my bonds which have a guarantee and a float above some short term rate, which provides at least some protection against a rise in rates and inflation. So, as an example, I trimmed recently 100 shares in two 50 share lots of the fixed coupon TC JZH, containing a long term senior bond from Prudential, and bought an equivalent amount of a CPI floater from Prudential maturing much earlier, PFK. That is my favorite way to hedge bonds from interest rate and inflation risk. That process would include buying some TIPs too. Another way is just to sell some fixed income securities that have rallied a great deal, particularly those bought at a large discount to par value and have rallied to prices above par. Then, my least favorite way is to buy a double short. I wrote an email to a reader last night that highlights some of the factors that I am currently evaluating on the timing issue:

"I am not going to do anything for at least a month as far as hedging bonds. But, I am not keying off the Fed statement. There are several other events which I view as more important for the long dated treasury paper:

1. The Fed will soon end its massive purchases of U.S. government paper. The N Y Fed discloses the timing and amount of these purchases. Federal Reserve Bank of New York - Permanent Open Market Operations These purchases,will ultimately total 300 billion, a form of money creation called quantitative easing.

2. The U.S. government will continue to supply the market with U.S. debt paper after the Federal Reserve Bank ceases to be a major buyer.

3.Those two events will occur at about the same time as an acceleration of GDP growth in the U.S. in the 4th quarter of 2009 and into the first half of 2010, fanning the perception of a potential inflation problem, as more industrial capacity is used.

4. I am also predicting a year over year rise in CPI starting in the 4th quarter as negative numbers from 2008 are replaced by increases in the .2 to .5% monthly ranges.

5. The U.S. dollar will fuel inflation concerns as it fails to find much traction, now at a 1 year low against the dollar index basket of 6 major currencies: DXY Index Quote - US Dollar Index Future - Spot Price Index Quote - DXY Quote - DXY Index Price

So, if I am right, the Fed will no longer be in control but will be in a reactive mode in a few months, able to control the short rate by keeping the federal funds rate artificially low but the yield curve will start to steepen at the 10 to 30 year range, causing a fall in price and a rise in yield with the longer dated maturities."

I also noted some issues with the double shorts in another email from last night:

"All of these double short products have problems. The worse problems are in the sector double shorts and I believe the Chinese one has been really bad. I have seen some problems with TWM and SDS but nowhere near as severe. I do not have a problem with those two. Their major problem last year, when I bought and sold them successfully, was at the end of the year, when they paid enormous distributions. /Massive Dividends for Proshares ETFs/TBT add So if these are owned in a year like 2008 they need to be sold prior to December.

I bought TBT at 36.68 as noted in that post and sold it a few months later at 45.Sold TBT/Emerson/More on Dynamic Asset Allocation I noted in a later post an article about the tracking problems with TBTMorning Notes 6/3/2009: More on TIP Pricing/Sold PST/Record Spreads in 2 and 10 Year Treasuries/Australia GDP In that last post I also gave myself an A+ in the theory of then using TBT to hedge long term corporate bonds and a D- implementing the theory. I did not note a significant tracking problem during my prior holding period from December to April. The reasoning for buying PST and TBT to hedge long term corporate bonds back then was explained in these post: Rally In Long Term Investment Grade Corporates/TBT/BTE/AVY/REITS

Since I am short on time today, I thought that it would be easier just to quote those emails.

I would add that I am comfortable using the double shorts as hedges, but I am an experienced investor with forty plus years under my belt making a limited and relatively small short term use of them. Due to their tracking problems and volatility, they are simply not appropriate for almost all individual investors as several recent publications have pointed out and many brokerage firms are starting to restrict their use. I use them in small amounts and over short durations since they give me more bang in hedging for my buck.

2. Revisionist history at Work: The NYT columnist Jeff Sommer, when summarizing the views of market strategist David Rosenberg, said that Rosenberg "did not expect so robust of a rally" NYTimes That is not how I would have characterized Rosenberg's view, as if he had called for a 30% rally off the March low and was surprised by a 58% burst. In fact, Rosenberg was calling for no rally at all the weekend before the rally started in early March and was instead forecasting a continued decline. This is how Allan Abelson described his soul mate's view on March 9, 2009: "Which has prompted David to advise caution to any of Merrill's clients tempted to believe that, with the stock market down 56% from the peak, the all-clear has been sounded. For he's firmly convinced that "the worst" has yet to be priced into this market." Assuming Alan did not make this up, it does not appear to me that David was expecting a rally, robust or otherwise, but a continued decline into the abyss. Just about three weeks later he was predicting a range of 475 to 600 on the S & P 500. Merrill's Rosenberg

I do share Rosenberg's view that the U.S. stock market is currently in a long term secular bear market. The rally off the March low does not disrupt the historical pattern of a long term secular bear market. We are still sitting at early 1998 levels, after almost 12 years, which is by my definition only consistent with the secular bear market pattern. That would never happen in a secular bull market. The current rally is consistent with the kind of rally experienced in the prior long term secular bear market, the cyclical bull phase between 1974 to 1976 of the 1966 to 1982 secular bear market, where the market gained more than our current rally off the March 2009 low. It is also consistent with the start of a long term secular bull market. The issue then becomes whether or not the conditions are ripe yet for the start of the long term secular bull market. To assess that issue, I just ask myself what is going to replace the Age of Leverage, where growth was financed by ever increasing borrowings, by both consumers and governments, until the debt load of consumers reached a level that could not be supported by disposable income. A related issue is whether the damage to the economy has had sufficient time to repair itself so as not to interfere with a prolonged spurt in GDP growth. How you answer those type questions will determine whether or not you believe the current rally is part of a long term secular bear pattern or the start of a new long term secular bull.

I do disagree with Rosenberg's characterization of the long term bull and bear cycles as lasting 18 years, his start of the current bear cycle in 2000 which is what most people do, and his opinion that another 9 years is left in the current bear cycle.

Part of the problem is that you do have to look back to make a clear delineation in the cycles. And, no one can go into the future and make that determination about what is happening now. I can say that if the S & P is around 950 or 1000, or 1200, in 2018, Rosenberg would be right. I just do not view that as realistic. Instead, my fifteen or sixteen years for a normal bear cycle, with the Great Depression simply being about five years longer due to the severity of the downturn, will result in the current cycle's end in 2012 to 2013. At that point, looking back to 1997, the S & P 500 would still be range bound within a fifteen to sixteen year period, which is how I define a long term secular bear market. A long term movement, defined by a series of cyclical bull and bear markets, where we end up about where we started the period, is my definition of a long term bear market. If this comes to pass, something will happen in a year or two that will cause a loss of confidence again, take the air out of the current rally, and keep the averages in the range bound pattern of a long term secular bear market. On the source of that problem, I can only hazard a guess. The most likely potential causes would be the withdrawal of fiscal and monetary stimulus, the lack of consumer demand increasing sufficiently to generate growth, and possibly incipient inflation that causes a tightening by the Federal Reserve.

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