Friday, February 8, 2008

Unfavorable Market Conditions

The Market

The market was in an overbought condition last week, but the latest pullback has fixed that. At this point, the next short term move is a toss-up. This suits our hedge position perfectly. Yesterday, for example, the Dow was down over 170 points. Most of our acccounts, however, were pretty close to break-even. Today, the market was slightly up, but we enjoyed a very nice increase in account values.


Why hedge? When the market hasn't shown a clear sign what it is going to do next, it would be nice to have positions that will do BETTER than the market if it advances. Since it may also go the other way, it would be nice to have positions that will make us money there as well. By effectively buying positions that help offset each other, we are taking a "Market Neutral" stance. If we are lucky enough to do it right, in an increasing market, our out-performers will beat the market enough that they will pull our hedge positions along well enough to at least match the upward return of the market.


If the market decides to go south, our hedge positions will increase in value and hopefully our stock positions won't go down too dramatically, thus decreasing our overall account value less than the market declines. Properly executed, our hedged portfolio should give us major market return with substantially decreased volatility. The perfect answer for a time when the market is giving us no short term direction.


Intermediate Term: Down


An ominous scenario is potentially setting up. If the market decides to pull back further and break the lows it just set a couple weeks ago (remember the last low broke the lows set this summer) and then immediately spikes up 200 to 400 points -- then look out. This is the pattern that historically has preceeded crashes. I have no idea if this will follow through, but I will definitely be watching.


In the end of November, the Dow broke a major support level before bouncing back (see #1 in Figure 1). The piercing of this major support level changed our long term trend from positive to negative. Now, we would expect any upward movements in the market to top out lower than the high of the last upward movement (notice last top in Figure 1 is lower than previous top). On the same hand, the next low should be lower than the last. Lower highs and lower lows are the definition of a down trend.


dow-current.gif


Figure 1


Let's look at how the Dow acted through the last recession and compare how it is setting up now. Figure 2 shows how the major lows consistently broke below the low prior to it. These are numbered from 1 to 7. The highs were initially trying to go higher, but were turned away at the previous highs. Eventually they began to top out lower than the previous highs.


dow-recession.gif


Figure 2


Recession Watch


Partial reason for the nice bounce off the support levels last week were news from the Fed. They hyped further liquidity to the financial markets by buying back $40 billion of treasuries (known as "repos"). Unfortunately, the rest of the story is that these were coming due anyway this week. $39 billion of repos were due and will be simply getting a different maturity date. The market finds this out and we get a couple major down days back to back. We've heard the heralding of hundreds of billions being pumped into the market to prop up the ailing financial system. In all reality, only about 18 billion has been added.


The Fed is doing us a great disservice. They are inflating our currency at rates that haven't been seen for 30 years. This results in DECREASING it's value. This causes the economic hangover to be worse when they slow down the inflating process. The opposite of inflating is depressing. Yes, depressions are the natural product of wild, out of control periods of inflating. Historically, the Fed won't let the cycle take it's full course and it will begin inflating again before a full blown depression occurs, causing a mild depression or "recession".


Where do we go from here?


I truly believe we will be taking off long positions soon and replace them with further shorts such as SKK, SKF and MZZ.

You can check out my website at 401k plan facts






No comments: