The Active Indexer: Defense Pays!

November 29, 2007

The latest installment of the Active Indexer reviews his results and takes a look at the growing dominance of high-quality assets.

The market climate has changed significantly since my last Active Indexer installment at the end of July 2007, which was “Offense-Defense Part II.” The last issue closed with Portfolio A’s holdings: Its offensive positions held long gold, gold stocks, Japanese equities, energy stocks and other high-quality stocks; it had taken defensive positions shorting low-quality stocks and in anti-carry trades. Portfolio A has been a defender of capital during this year’s summer and fall declines. After ending July 2007 with only a 2.0% year-to-date return, Portfolio A has climbed 10.4% to 12.4% year-to-date compared with the S&P 500 Index’s -0.8% total return through November 26, 2007. Most of the data that follows runs through November 15.

The portfolio’s long- and shorter-term thesis is restated below:

  • Portfolio A’s Secular (long-term) Investment Thesis: The secular trend favors low-quality (LQ) assets (small-caps, emerging markets and commodities) over high-quality (HQ) assets (large-caps, growth stocks and investment-grade bonds).
  • Cyclical Trend and Risk Control: The cyclical trend (shorter-term than the primary secular trend) favors high-quality assets over low-quality assets. (A big correction is near, so tilt to defense.)

After revisiting our thesis and Portfolio A, our focus will turn to the unfolding credit crisis with its tipping point being the bursting of the housing bubble in “Too Close to the F.I.R.E. to See the Smoke!”, which will be posted shortly. This article will build upon works published in the spring and fall of 2006, namely, “Peak Risk” and “Escape from Normalville.” It will show how our little credit mess has grown from a few billion dollars in losses to what will likely be seen in 2008 as a more than $1 trillion crisis. We haven’t seen anything yet!

Until then, let us reaffirm observations made in the first installment of Active Indexer, which was submitted in July 2006.

“The second quarter of 2006 became a time to overweight to HQ sectors and telecommunications (under loved and undervalued) while neutral weight energy (good values in-spite of HQ cycle) while under-weight basic materials, and other cyclicals such as technology, airlines, autos, etc., and also under-weight speculative sectors such as bio-technology.”

Although the July 2006 quote shows us to be too early with an underweight in basic materials, we remained overweight to gold and gold stocks, and we generally got the other sectors right. The hardest call was to envision HQ assets outperforming relative to LQ assets after more than seven years of LQ dominance. This report focuses on the strengthening dominance of HQ issues since May 2006 and July 2007. It also relates HQ-LQ cycles to asset diversification and sector rotation within earnings and business cycles.

In our last issue, which was written well before the S&P 500’s 9.3% decline from July 19 to August 15 and the 12% intra-day decline (July 19 – August 15), we stated that “LQ to HQ rotations are harbingers of broad market corrections.” Historically, the pain does not end until the S&P 500 declines 15%-30% or more.

HQ:LQ Relative Performance Ratios

The S&P 100 Index ($OEX) and the iShares S&P 100 Index Fund (AMEX: OEF) represent 100 of some of the largest firms in terms of market capitalization (cap) in the United States. The blue chips that make up the index provide consistently higher earnings and dividend growth than the smaller companies. The Russell 2000 Index ($RUT) comprises domestic small-cap stocks and underlies the iShares Russell 2000 ETF (NYSE Arca: IWM). $OEX firms have higher-quality ratings on earnings growth with less credit risk than the lower-quality firms found in $RUT. Dividing $OEX returns by those of $RUT provides a relative performance ratio of high-quality to low-quality stocks.

Figure 1 depicts an HQ:LQ ratio, $OEX: $RUT, as a green line. When this line falls, LQ stocks are performing better than HQ shares. When it rises—as it has since May 8, 2006—HQ assets are outperforming LQ assets. Prior to May 2006, LQ assets had dominated HQ assets in terms of performance for seven years.

Figure 1. $OEX Returns And The $OEX: $RUT Relative Return Ratio

IWM closed at $77.63 on May 8, 2006. This date is significant because it represents peak momentum in IWM shares. Weekly closes below this price have produced deep corrections.

On November 9, 2007, IWM closed the week at $76.85 (Figure 2). Based on past corrections, IWM should test its prior lows near $73.25. If this support holds, stocks should resume their upward trends. However, a break below this support should cause IWM to fall to at least the $68­-$72 range for a correction of 16%-21% off its July 19, 2007, high. In the event of such an occurrence, OEF should follow IWM with a correction of 10%-15% (to $62-$65). If this happens, we’ll be in a formal bear market, and a nasty technical pattern involving lower lows and lower highs.

Figure 2. IWM Has Seldom Closed Below Its May 8, 2006, Price

On November 13, IWM rallied about 3%. Until it breaks above $84, it remains in a downtrend. And it faces an initial technical test at $80. While a close above $80 would signal a possible end to the current correction, a close above $84 would be a much stronger indicator.

There is additional evidence that the rally kicked off by the Federal Reserve’s rate cut on August 16, 2007, might have been a bear trap. Stock indexes are not on firm footing when less than 40% of the New York Stock Exchange’s issues are trading below their 200-day moving price average ($NYA200R). It is very rare for us to see $NYA200R at <40% again after the market has rallied from that level to the point that more than (>) 60% of NYSE issues are above this indicator within the previous seven weeks. This generally only happens when stocks are at least going to test their prior lows from the previous corrective trend, which in this case began on July 19, 2007. A test near 1370.60 (the prior low) for the S&P 500 is expected because, as Figure 3 shows, it just happened!

Figure 3. Seldom Are So Many Stocks Below Their 200 DMA Price

One of the central tenets of trend following is that fundamentals must sustain primary trends. Figure 3 causes us to pause and question the underpinnings of stock advances following the corrective lows experienced by the major indices on or around August 15, 2007.

Pieces To The Puzzle
Recent fundamental weakness in earnings growth and stock leadership makes it less likely that stocks will advance to new all-time highs anytime soon. A shift to HQ leadership indicates that the market is near a turning point in the current trend. The rotation from LQ to HQ was 14 months old when the correction began on July 19, 2007. The duration of the 2006-2007 rotation is within the range associated with the onset of prior bear markets. More pieces to the puzzle need to be in place for the bear’s entry, which to the surprise of many investors, probably will not be accompanied by higher federal funds and short-term Treasury rates (Figures 4 and 5).

Figure 4. Since 1998, Stocks Have Mostly Declined After The Fed Cut Rates

Figure 5. Since 1998, TSY Note Yields And Stocks Have Been In Sync

The relative strength in the price performance of HQ- over LQ-classified firms (from a sample of nearly 1,000 companies), as determined by the Standard & Poor's Quality Ranking System, has usually preceded weaker economic growth (Figures 6 and 7). This observation alone tells us that we are either near the end of an aging bull market, in the infancy of a bear market (and an economic recession) or about to experience an earnings recession. All outcomes are likely to deliver a 15%-30% or greater correction.

On May 8, 2006, we began a cyclical correction in LQ assets. This rotation began with domestic small-cap stocks, which have repeatedly fallen below their prices on that date. Commodities, domestic small-cap stocks and emerging market securities are the initial leaders in an LQ-dominated cycle, because they benefit the most from the excess liquidity and tight credit spreads (caused by low fears of default) that fuel these cycles.

HQ leadership starts when the fear of default risk rises, as it has most certainly done this year with the subprime mortgage crisis. We give little weight to low corporate bond default rates because credit default swaps have artificially suppressed default rates well below their norms.(1) The next shoes to drop will be consumer credit vehicles, municipal bonds and high-yield credit.

A rotation away from LQ to HQ leadership is evident after one of the many LQ asset classes loses its performance leadership relative to competing HQ asset classes, as occurred with the rotation from $RUT to $OEX that began in May 2006. In 1997-1998, it was the emerging market stocks that were the first to resign their leadership to large domestic growth stocks. Large-caps were the leaders during the final stage of the 1990s bull market.

Figure 6. S&P 500 Reported Earnings And Sustainable Growth, HQ And LQ Cycles

Figure 6 charts the market’s 6% annualized (sustainable) growth rate (red line). Reported earnings growth seldom rises above this line. The green line graphs the S&P 500’s reported earnings growth on a 12-month trailing basis. The green line’s deviations above the red line represent LQ-dominated cycles, while sojourns below represent HQ cycles.

It is important to note that from September 1998 to March 2000, a little more than 50 technology and telecommunications issues with P/Es north of 70 led the market’s charge higher. The large-cap growth stocks (mature issues with consistent earnings and high dividends) did not regain leadership away from tech-telecom (cyclical growth stocks with erratic earnings and low yields) until March 2000. From then through September 2000, the tech and telecom stocks lost 16% of their market cap in what would eventually be an 86% decline, while utilities gained 43%; financials, 39%; health care, 24%; consumer staples, 10%; and large industrials, 6% (in an LQ-to-HQ rotation).

HQ led the final stage of the last bull market (as is customary). Yet, from September 2000 through September 2002, only the consumer staples and basic materials sectors avoided a 20% or more loss. Staples were up 4%, primarily because of their consistent earnings and dividends, while basic materials rose 2% because they were undervalued. Many good stocks declined severely because there had been excessive high-margin speculation in about 100 popular issues; consequently, when margin calls came, the good was sold with the bad. August 2007 was only a prelude to the liquidation phases that still lie ahead.

Defense in the last bear market was restricted to small- and mid-cap value stocks, which gained 3% and 4%, respectively. These stocks registered positive returns because they were undervalued and because speculators did not heavily leverage them. Thus, they did not see as much liquidation as the big names. Sampling methods that limited cyclical growth exposure, as the S&P 500 Equal Weight Index does, or active strategies that selected issues with healthy fundamentals, as the FTSE RAFI U.S. 1000 Index does, cut losses significantly—to 24% in the case of the S&P 500 Equal Weight Index and 20% in the case of the FTSE RAFI U.S. 1000 Index. The S&P 500 and other cap-weighted indexes, by contrast, saw losses of 42%-50%.

Since 1975, a sudden downward revision to reported earnings has been associated with peak earnings. Figure 7 shows the first significant evidence from the professionals at S&P that earnings have peaked. Their revisions confirm the LQ-HQ rotation as a rational discounting of stock prices.

Figure 7. S&P Cuts 2007 Reported Earnings By 7% From $84.69 To $78.92

(Ron Griess ( produced Figure 7. He granted permission for its inclusion here.)

This is big news! Standard and Poor’s just announced a cut on estimated S&P 500 earnings for 2007 by 7%, which results in a 3.2% year-over-year decline. “Offense-Defense, Part II” warned: “currency-sourced liquidity risk associated with profit and credit cycle peaks are very dangerous factors that are in play during 2007.” The pieces are falling into place for the market to correct errors.

The Most Recent Trade
Past Active Indexer articles have provided a depth of information about how the yen and Swiss franc carry-trades have pumped massive amounts of leveraged liquidity into risky assets. Being on the other side of this trade in 2007 has reduced Portfolio A’s volatility and hedged losses during recent equity corrections.

On November 5, 2007, long yen positions were increased from 5% to 10% (using Rydex’s CurrencyShares Japanese Yen Trust; NYSE Arca:FXY) and a 5% position in the Swiss franc was initiated (using CurrencyShares Swiss Franc Trust; NYSE Arca: FXF). This was a timely trade. During the week of November 4, these currencies advanced 3.5% and 2.8%, respectively, ranking their performance that week at No. 1 and No. 2 among the world’s 14 major currencies. We increased our anti-carry trade (the yen and franc are low-yielding currencies used to finance speculation) exposure because we expect a disorderly adjustment in global currencies. Many currencies have had their fundamental price trends suppressed by central banks and sovereign funds that source their assets from petrol-dollar and other export-dollar trade proceeds. This artificial suppression should be relieved after the carry-trade dies, which could ignite violent currency adjustments that would cause a contagion of volatility across most asset classes and result in more trades unwinding.

Portfolio A has profited from the corrective LQ-HQ cycle begun in May 2006. It is ready to defend during what may be a violent discounting period. Investors can view Portfolio A’s performance right before the Appendix. The Appendix lists Portfolio A trades in 2007.

Position Snapshots

On November 20, 2007, we sold 19% of Portfolio A’s assets—namely the Bancroft Convertible Fund (AMEX: BCV), Pharmaceutical HOLDRs (AMEX: PPH) and Telecom HOLDRs (AMEX: TTH). BCV is the only fund not held for more than 12 months. We still have some losses from covering shorts earlier in this tax year to offset resulting gains. If needed, additional transactions could offset capital gains.

We sold these funds in our portfolio because of concern about BCV’s credit risk and PPH’s exposure to political risk. While TTH still holds value, we need foreign exposure with an eye for quality. Eventually, we will reinvest two-thirds of the sale proceeds—or 11% of the portfolio’s assets—in PowerShares FTSE RAFI Developed Markets ex-US (NYSE Arca: PXF) near a target price of $46. Another 4% of the portfolio will be invested in the iShares Lehman 1-3 Year Treasury Bond Fund (NYSE Arca: SHY), and the remaining 4% in the Vanguard Health Care ETF (AMEX: VHT); both funds are currently in the portfolio. For now, all of the sale proceeds will sit in SHY.

Figure 8. Portfolio A Sells: BCV, PPH, And TTH

The PowerShares Deutsche Bank G10 ETF (Amex: DBV) selects the three highest- and three lowest-yielding (bills) currencies from the 10 largest developed countries. DBV then shorts the low-yield currencies and goes long the highest yielders. On April 13, 2007, we went from holding 5% of assets long in this ETF to being short 5%. We had a 5.6% gain while long and a 1.9% loss since being short, for a net gain of 3.7%.

Shorting DBV has been more delightful than being long, because the carry-trade is the root of a lot of evil. I like being on the right side of Karma. People laugh when I refer to it as my reverse liquidity trade. It truly is. It rises when most of everything else is being liquidated. This short reduces daily volatility. My research on shorting this trade is paying off. When the credit crunch passes, we may go long DBV again.

The notes in Figure 9 highlight an unexpected benefit. The price direction of DBV in early morning trading often has forecast the daily direction of major stock indexes at their close. This chart has not been updated since November 12 because at 11:35 a.m., DBV was down -2.3% while the S&P 500 SPDR (AMEX: SPY) was up nearly 1%. My time-stamped notes found at the bottom of the chart read: It is very likely that SPY will follow DBV down. Well, SPY reversed direction to close down a little more than 1% that day. The prices in your portfolio guide you; watch them and learn their message.

DBV Shorts, 5%

Figure 9. Shorting The Global Carry-Trade Defends S&P Losses

We have been short the iShares MSCI Emerging Markets Index Fund (NYSE: EEM). In June 2006, one-half of EEM shorts were covered, and in August 2007, a third of EEM shorts were covered. In both trades, EEM’s price was between its 200- and 400-day moving average (DMA) prices. It is best to re-short to the same degree when EEM rises more than 15% above its 200 DMA. We were too eager to re-short EEM on our last trade, which hurt performance, so follow your disciplines. Currently, EEM ($155.50) is about 18% above its 200 DMA ($131.46). We will most likely cover some shorts near a share price of $120 (Figure 10).

Recall from “Offense-Defense, Part II” that asset classes and sectors are measured for their market beta, economic beta (Real Gross National Product – RGNP), and credit-spread sensitivity, or default risk beta. A matrix is employed to balance portfolio exposures to these sensitivities. This discipline enables us to develop reasonable performance parameters. Portfolio A seeks a 4%-8% real return annualized over a full business cycle. Risk is managed with a keen eye to the downside. The portfolio’s annual standard deviation is expected to lie between 4 and 6.

EEM shorts primarily hedge RGNP beta. When the market sniffs recession, EEM has historically declined before and to a greater degree than most other assets and sectors.

Price Speaks
It is time to listen. Let the charts speak for themselves.

EEM Shorts: 17% of Portfolio

Figure 10. Emerging Market Shorts Hedge Economic (RGNP) Beta

Figure 11. Yen Is Mother of Global Liquidity, Longs Hedge (Credit) Beta

FXY Longs, 10%

Figure 12. Yen ETF Hedges Equity Declines

GLD Longs, 16%

Figure 13. Since May 2006, Gold ETF +10% While Gold Shares ETF Flat

GIM Longs, 4%

Figure 14. Since 2002, Templeton Global Bond FD (GIM), +107%, $USD, -38%


JPP Longs, 4% and JSC Longs, 3%

Figure 15. Gold Also Hedges Foreign Equities Exposed To Deflation Risk

PRF Longs, 11%. BQY was sold on 08-02-07 because of its 34% weight to financials. Half of the proceeds purchased PRF shares.

Figure 16. FTSE-RAFI Bests S&P’s Quality Of Earnings Model

RSP Shorts, 11%

Figure 17. FTSE-RAFI Bests Rydex S&P 500 Equal Weight Idx

SHY Longs, 14% and soon to be 18%

Figure 18. 1-3 Yr T-Note Prices Rise & Hedge S&P 500 Losses

VHT Longs, 4%, soon to be 8%

Figure 19. Overweight Health Care Due To Value & Relative Strength

XLE and OIH Longs, 5% and 2%

Figure 20. In Corrections, HQ XLE Bests LQ OIH

FDFAX Longs and XLY Shorts, 5% and 14%

Figure 21. Staples Are Stable, Discretionary Stocks Fall

Figure 22. Time To Cover XLY Shorts…?

Enough Is Enough ... Not!

Repetition helps investors to focus. Here are more quotes from “Offense-Defense, Part II”:

"Severe corrections in low-quality credit have always been accompanied with equity declines of at least 10%."

"This cycle ends when the credit market fairly prices default risk."

Bill Gross, the chief investment officer at Pacific Investment Management Inc. and the manager of the largest bond portfolio in the world, recently stated that the subprime and alt-a problem exceeds $1 trillion and that he expects to see some $250 billion in defaults. That's big stuff, folks!

After reading our soon-to-follow Active Indexer installment titled: “Too Close to the F.I.R.E. to See the Smoke!”, you’ll see that $250 billion has already been burnt. The coming firestorm will burn $500 billion to $600 billion (derivative-sourced defaults), with another $600 billion in liquidity lost in bank lending capacity. We may be in the midst of The Mother of All Credit Crunches, so watch your ass...ets.

End Notes
(1) Garth Friesen of III Associates, "Crisis? What Crisis?," Institutional Investor’s Alpha, October 2007.

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