Defend & Advance

March 10, 2008

The Active Indexer is back: Serrapere's portfolio outperforms in 2007 and early 2008.


Much like the New York Giants, who advanced their way to a Super Bowl victory on February 3, 2008, Portfolio A turned around a weak start to 2007 with a strong finish, thanks to a GIANT DEFENSE. As the quarterback of Portfolio A, I empathize with Eli Manning’s last-minute victory drive. Eli and I sweated out the early part of the season with a weak offense and an adequate but not fully blossomed defense. In the end, defense put us in a position to win. The "A" team’s shorts on low-quality stocks, high-quality longs, anti-carry trades and U.S. dollar hedges scored points in the fourth quarter of 2007. They then kicked off 2008 with impressive gains.

At times, my patience ran thin (as did the patience of NY Giant fans). I held my positions because I was convinced that we had the right plays to win in the market climate that I anticipated, and that eventually manifested. Being up 8.8% and besting the S&P 500’s 5.5% return in 2007 was satisfactory because we met our absolute return objective.

Gratification Comes From Playing With Style

The "A" team hedged market losses in 2007. In January 2008, Portfolio A rallied 4.9% while the S&P 500 (S&P) slumped 6.1%. Year-to-date through Feb-2008, "A" is up 8.1% while the S&P is down -9.3%. From A’s March 19, 2004, inception date through Feb-08, the portfolio has netted 57.2 % compared with the S&P’s 24.9% and the Hedge Fund Research Institute Investable Index’s (HFRX) 17.9% return, which works out to 12%, 5.7% and 4.2% annualized (Figure 1). Figure 2 compares the monthly returns of Portfolio A to the S&P from Jan-07 through Feb-08. The same comparison for nearly 48 months (Mar-04 through Feb-08) can be found in Appendix A (Figure 23).

Active Indexer aims to show how to build your own hedge fund. It is rewarding. Portfolio A has come through as a hedge fund without the associated baggage of what Steve Leuthold of The Leuthold Group, LLC calls the 2 and 20 crowd.1 Mr. Leuthold has been very critical of hedge funds. I aspire to attain his style, which Steve calls making it and keeping it, when the crowd is giving it back. We stand on the shoulders of others. Steve enables us to recognize true value. If you want a great manager, he is it!

It is time to pick a fight with the Greenwich/Hamptons elite over hedge funds that charge investors 2% management fees plus 20% incentive fees. If you consider their single- to low-double-digit returns—especially after you factor in the illiquidity, low transparency and the higher business risk associated with most partnership formats—the costs are too high, in my opinion. They will soon lower their fees or go out of business if more investors learn to build and manage their own hedge funds. Exchange-traded funds (ETFs) enable us to fashion our own hedged portfolios with or without 2 & 20 investment structures.

As Michael Steinhardt, one of the most prominent hedge fund managers of all time, said during a recent interview on "60 Minutes,"you have to be stupid to pay 2 & 20 for high single- or low double-digit returns.2 My own view is that for these absolute returns, investors should be paying no more than 2%-3% versus the 4%-6% annually that is typically paid to invest in most hedge funds. Those investors deserve a 50% discount. And today’s investors are getting less than they were before hedge funds got hot (in the early 2000s). According to Mr. Steinhardt, hedge funds provided net returns north of 15% yearly during the 1960s through the early 1990s.

Mr. Steinhardt’s observation is borne out by HFRX performance. During the sample’s first nine years (1989-1998), it recorded a 13.3% annualized return. Since 1998, this index’s annualized return has declined to 9.4% through 2007. In spite of a bull market since September 2002, HFRX has provided a paltry 6.5% yearly return. HFRX continues to hedge a sizable degree of market losses, yet investors are definitely paying more for less. Prior to year 2000, most hedge funds charged a 1% management fee plus a 15% or a 20% incentive fee; now it is mostly 2 & 20. With their lower returns and higher fees, hedge funds are too dear. In the future, the 2 & 20 scene will be reserved for a few star managers.

Warren Buffett’s Take: "The hedge fund mania will fade with time as have past manias." In a CNBC interview on March 3, 2008, Mr. Buffett explained his negative opinion. He does not expect thousands of hedge funds to harvest market-beating returns after deducting their high fees and trading costs. Mr. Buffett adamantly believes that it is difficult enough to beat thousands of your peers before customary fees, let alone in 2 & 20 structures.


2007 Market Views And Portfolio Adjustments Went Against The Odds
We braved the odds when we claimed in "Defense Pays" that the market’s rally to new all-time highs in the fall of 2007 was running on weak legs. Below are some quotes from this November 2007 issue.

  • There is additional evidence that the rally since the Federal Reserve’s discount rate cut on August 16, 2007, might have been a bear trap.
  • Stock indexes are not on firm footing when less than (<) 40% of New York Stock Exchange issues are trading below their 200-day moving price average ($NYA200R).
  • A test near 1370.60 (the prior low) for the S&P 500 is expected.
  • The next shoes to drop will be consumer credit vehicles, municipal bonds, and high-yield credit.
  • August 2007 was only a prelude to the liquidation phases that lie ahead.
  • 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 that came off the August 15, 2007 corrective low prices for the major indices.
  • Recent fundamental weakness in earnings growth and stock leadership makes it less likely that stocks will advance to new all-time highs. A shift to HQ leadership indicates that the market is near a turning point in the prior 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.
  • "LQ to HQ rotations are harbingers of broad market corrections." Historically, the pain does not end until the S&P 500 declines 15% to 30% or more (restated from Offense-Defense Part II, July 2007).

These were very bold pronouncements given that the market’s performance from November 1 to April 30 usually bests its performance from May 1 to October 31. According to Jeffrey A. Hirsch’s Stock Trader’s Almanac, since 1950, over 80% of the market’s cumulative yearly advances have accrued during the late fall to early spring season. Many traders have warned if you sell in November, you stay and pray! I usually adhere to their axiom of to sell in May and go away! It usually does not pay to go against the Almanac, but I had a lot of evidence that stocks were likely to resume their declines during what typically is a strong seasonal price pattern for market indices.

Efficient market players are forever ready to declare aspiring market beaters dead! They take a shoot-to-kill stance on managers if the market moves against them. I am a Bear who sought shelter in defense. Survival comes from preserving enough capital to profit from the next Bull market, whether it is bred from another asset bubble or cultivated from undervalued assets—or both. Survivors know when they are investing and when they are speculating. They weigh risk and reward. Victor Sperandeo taught me to invest in Bull markets and to preserve capital while speculating with a limited amount of capital in Bear markets.3 It pays to listen.

This Is Not Science. We Are Simply Estimating Risk And Reward

The market cycle since 1994 has been an induced business cycle feed from excessive debt creation that inflated an emerging market bubble that burst (1997-1998), and then a domestic technology-telecom bubble that burst (2000-2002). We have just witnessed the end of a generalized credit bubble built around a housing bubble bred on financial securitization (risk intermediation). The turmoil seen in the credit markets since July 2007 might end up being the Grandfather of all post-World War II credit contractions that ushers in the second Bear cycle in the Mother of all Bears for the 21st century. Crisis begets opportunity, and there currently are stocks and bonds to buy at great values and there will soon be many.

Markets Move In Technical Price Patterns Supported By Economic Fundamentals

Double top formations are very bearish technical patterns. A double top is more likely if other indicators confirm it. The first top in the S&P 500 (and other domestic stock indices) was in March 2000, with the first bottom in October 2002. The second top might have been in October 2007, with the second bottom evident soon or many months away—and at prices that drive stock indices much lower than recent lows.

Market technicians (chart readers) label these price patterns as double tops and double bottoms. Figure 3 depicts what might be developing as a secular double top for the S&P 500, with the first top formed in 2000 and the second in 2007 near 1550. The first decline bottomed near 780 (-44% off the first top) with the second bottom projected to lie between 960 and 1152 (-27% to -39% below the second top, 1576.09). Why? A stock index’s 4-month moving price average (MA 4) usually declines below its 12-month moving price average only when stocks are in the midst of a 20% or more decline off their prior top. Consequently, we expect the S&P to decline to at least 1230, which is 7.6% below the S&P’s Feb-08 month-end price and -22% off the high.

It is highly likely that the economy either is in or headed into a recession, which implies at least a 28% decline from the prior top–a decline to 1135 on the S&P. Twenty-eight percent is the typical decline associated with all recessions since 1960. Since then, stocks have declined prior to the onset of recessions and bottomed before their end. S&P 960 equals in inflation-adjusted terms, the price near-bottoms made between July 2002 and March 2003. Since nearly five years have passed since the first bottom, a successful test of this bottom (support) will most likely be higher than the prior bottom, near a price of 960 or 1152.

Fundamentals Usually Align With Technical Price Patterns (Especially When Measuring A Full Business Cycle)

Figure 4 shows the S&P reported earnings for 2008 at $67.90, which represents a 20% decline from a June 2007 earnings peak. Reported earnings are graphed (green line) in relation to the S&P’s 6% historic trend line growth (red line). Standard & Poor's posts various earnings estimates on their Web site. The 2008 estimate is 5.3% below 2008 Q4 results. Notice how the oscillation of reported earnings above and below the S&P sustainable trend line is nearly symmetrical. Extreme earnings above the trend line precede plunges below it.

A long gaze at Figure 4 caused me to adjust earnings so they more closely track corrections that have followed prior earnings peaks. Our objective is to depict the median of all corrections after prior peaks. The median correction ended with reported earnings 31% below the S&P’s sustainable earnings trend line, which corrects current earnings to about $48. Figure 5 employs 10 years of normalized earnings at $49.69.4 Since this is not science, any estimate within $2 of highly volatile earnings works for estimating the downside. Our estimates are more reliable because these two methods produced nearly identical results.



The average of all reported earnings from December 1997 through December 2007 is 42% below the 2007 Q2 peak and 28% below the long-term trend line. Figure 5 graphs a correction in earnings down to the S&P 500’s normalized earnings level. The oscillation of reported earnings from the 2007 earnings peak now looks more like prior corrections. Notice that the resulting price-to-earnings ratio (P/E) is the same (14) in Figures 4 and 5. However, the price for the S&P in Figure 5 is 27% lower than it is in Figure 4 because lower stock prices need to compensate for a weaker "E" in the P/E. A P/E estimate of 14 is conservative because the average P/E near market bottoms after P/Es have exceeded 20 is a little more than 9. A P/E of 9 implies an S&P price near 450 and a -71% price decline from the market’s all-time high.

A P/E of 9 is not likely because the Federal Reserve is doing everything possible to inflate our way out of a credit crisis. They will most likely continue to pump $30 billion to $50 billion per month into our financial systems until the banks are relieved of their constraints on capital. Under these circumstances, P/Es near 15.8 seem more likely than 9. These assumptions result in a bottom for the S&P 500 somewhere in the range of 972 to 1152.

Figure 6 applies various S&P earnings levels assuming a constant P/E of 15.8 (the market’s average P/E since 1940). Doing so provides S&P price levels 40% lower to 19% higher than the index’s Feb-08 closing price. Notice that with an associated P/E of 15.8, the S&P’s Oct-07 price peak was within 0.22% of its potential under current 2008 operating estimates (these S&P estimates are too high).

A 20% contraction in earnings ($67.90) is close to the average seen during recessions since 1960. Increased economic globalization will not prevent a recession. However, globalization and Fed pumping will most likely mitigate losses. My estimates are very far from the worst-case scenario. Most investors do not view declines of 19% below last month’s close and 31% below the autumn high as moderate estimates, yet they are!

Investors often cite low 10-year Treasury Note yields, which hovered near 3.75% for much of Feb-08 as supportive of higher stock prices. They cite earnings yield (EY) ratios of 1.98, 1.44 and 1.30, which result from dividing operating, normalized and reported EYs by the T-Note yield, as evidence that stocks are undervalued relative to bonds. Stocks might be better values than T-Notes over time horizons greater than three years, but high ratios did not indicate a bottom for stocks in 2001, and they may not now. Note yields declined from 6.7% to near 3.3% from January 2001 through June 2003 and so did stock prices. These ratios do not call bottoms when default risk is greater than inflation risk, which has been the case since July 1997. Figures 11-12 demonstrate the positive correlation between the Federal Funds Rate (and Note yields) and equity returns. Lower rates do not support stocks when investors fear a return of principal more than a real return on their principal.

Figures 4 and 5 reference LQ and HQ. These acronyms stand for low- and high-quality stocks in relation to a low and high consistency of historic earnings and dividend growth. LQ stocks lead the market when earnings growth rises above its trend line, and HQ leads after earnings peak and then correct to a trough. With current earnings near $72 and a reasonable risk that earnings might drop to $50, investors should overweight their portfolios to blue chip stocks within stable sectors of the market. They should then wait for an optimum time to add LQ issues to their portfolios. For a few LQ stocks, the time to buy is here or near (Figures 9-10). Individual security selection is for fund managers or investors with the time and talent.

Price Continues To Speak

It is time to recap past technical observations and estimates of market direction made in our November 2007 installment titled Defense Pays. Figures 7-15 are updated charts that capture some of the primary views expressed in past installments.

Technical analysis has seldom worked better than it has since July 2007. Uncertainty over hidden credit losses, fear of a cyclical earnings peak and a subsequent recession have created a technically driven market. This is what markets do when investors get too greedy or too fearful. The market tells us where prices should be. Figure 8 shows we were listening. The line and circle represent estimated target prices for large- (OEF) and small-company (IWM) stocks made in November 2007, which were spot-on.

Market prices are not knowable by the masses at extremes. Hysteria is manic-depressive. Prices must be rediscovered to adjust for risk premiums that were too low (1999 and 2007) or too high (1990 and 2002). Excessive greed and speculation in the credit markets drove the 2007 market out of bounds. A maddening crowd priced credit as they roared for more! Usually credit markets are the tail that wags the dog (equity markets); however, credit risk was so mispriced from 2006 to July 2007 that the Devil (credit) possessed the dog (equity markets). The credit market is many times larger than the equity markets, so the dog has and still has a lot to swallow.

An updated Figure 9 shows only 25% of all New York Stock exchange issues were priced above their 200-day moving price averages ($NYA200R). $NYA200R is in a buy zone (readings less than 25%) for investors willing to hunt through stocks to find bargains on issues that they can hold for at least five years. Get ready for some OFFENSE!

Bottom fishers should preserve bait for fish that swim in deeper waters. We have been watching $NYA200R since July 2007.


The Bulls are still hoping that Fed rate cuts will turn stocks around. They need to get with it! In July 1997, we entered a period of excessive currency devaluation initiated by the collapse of Asian financial paper, which resulted in 35%-85% declines in emerging market stock markets from 1997 to 1998. The response by global monetary authorities was to cut rates, which was coordinated with government fiscal stimulus—all of which led to excessive credit creation that developed into an induced business and investment cycle, the likes of which we have not seen since the 1920s and 1930s. This was the last time the Fed Funds Rate was positively correlated to stock prices (bond prices were very negatively correlated) for more than a decade.

We will continue to report on Figures 11 and 12 to see when inflation risk once again overrides default risk. Crude and commodity prices are telling us that the reassertion of this risk, which dominated the markets from 1968 through July 1997, will most likely be returning soon. The Fed sure hopes it does soon!

We did not part with emerging market shorts because they hedge recession risk. We expect to cover some near $124.

We first introduced Figure 15 in our March 2007 installment, Yen Rising, Dollars Setting, which made the case for employing a long yen (FSY) to hedge equity declines. In April 2007 and November 2007, we also initiated additional currency hedges. We added long Swiss franc exposure (FXF) and we shorted the carry-trade via selling short the shares of DBV.

A steep yield curve is bad for stocks and the U.S. dollar. It is great for inflation hedges (GLD, GDX) and short-term Treasuries (SHY). The red line in Figure 16 tracks the difference between 10-year T-Note and 2-year T-Note yields, which has widened dramatically since November 2006 in response to Fed rate cuts and greater inflation fears. Mr. Market hedges risk.

Hedges can be very volatile consequently; they need close monitoring. Portfolio A is overweight gold and gold stocks with a 15% allocation to GLD plus 15% to GDX. Figure 17 compares Hecla Mining Co. (HL) gross profits with price changes in the primary metals mined. Overweight positions are justified by strong top-down economic fundamentals (Figure 16) and by bottom-up, company-specific (and/or sector-specific) support. HL is one of many mining stocks tracked to justify our positions.

How Do You Value The Unknowable?

Chris Whalen, founder of, emailed me the quote below in reference to MBIA, one of the troubled monoline bond insurers that have rocked our world in 2008.

"Why did the investing public turn its attention from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend, i.e., to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and secondly, that the rewards offered by the future had become irresistibly alluring. The new era concepts had their roots first of all in the obsolescence of the old-established standards. During the last generation the tempo of economic change has been speeded up to such a degree that the fact of being long established has ceased to be, as it once was, a warranty of stability."

"The New Era Theory"
Security Analysis
Benjamin Graham & David Dodd (1934)
MBIA’s (MBI) stock price is pure speculation. In the January 31, 2008, press release included in the 8-K dropped on that date, MBI speculates that its reported losses from collateralized debt obligations (CDOs) WILL MOST LIKELY IMPROVE. Many value investors took heart from the company’s statement to substantiate their recent purchases of deep-value MBI shares.

Marty Whitman of Third Avenue Value Fund (TAVFX) has contributed much to our profession and he has an enviable track record. However, I cannot understand how Mr. Whitman (and other value investors) bought much of their MBI stock near $30 per share during 2008 Q4. Perhaps they should read (again) Chapter XXVII of Graham & Dodd, from which the quotation above was excerpted.

Mr. Whitman also bought mortgage insurer Radian Group (RDN) in October 2007 after the company announced heavy losses related to investments in the subprime mortgage market. In addition, in early September he grabbed rival MGIC Investment (MTG), the country's largest mortgage insurer. He most likely purchased RDN and MTG near $17 and $30.

Here is the opening line in "3 Bargain Stocks," an article by Yuval Rosenberg of Fortune published October 23, 2007:

Marty Whitman, the dean of deep-value investors, identifies stocks he considers 'safe and cheap.' His picks will surprise you.


Two of the three were RDN and MTG; the other was Forest City Enterprises (NYSE: FCEA), which closed at $55.87 on the Fortune article’s release date. It closed March 4, 2008 at $36.30, while RDN closed at $6.07 and MTG closed at $14.19. The losses from these bargains are staggering. FCEA is down -35%, RDN has plunged -64% and MTG cratered -53%. Figure 18 graphs the performance of MBI along with RDN, MTG and the Financial Select SPDR ETF (XLF).

MBI’s fair value price is not knowable consequently, its freely traded price is not fair value, it is speculation, which is why Mr. Whitman has close to a 60% loss on MBI shares purchased in fall 2007. Yet Mr. Whitman, who has made a name by buying assets most other investors shun, in January increased his stake in MBIA, the largest bond insurer, at $12.15 a share, and now holds about 10 percent of its outstanding shares. Perhaps MBI is another home run like the one he hit with Sears years ago, when he paid $10 per share and then sold most of his shares near $130. I prefer not to seek speculative values with TAVFX.

Value investors can pick from a cadre of fine managers. One manager who is becoming one of my favorites is David Winters, who launched the Wintergreen Fund (WGRNX) on October 17, 2005, after departing the Mutual Series funds. This fund offers global diversification and concentrated sectors bets with a star manager that compares favorably with Marty Whitman’s long-term performance history. WGRNX’s current bets are less speculative than those of TAVFX.

Mr. Winters is gaining more favor because his fund is up over 4.5% since July 2007 when the credit problems became a crisis (Figure 19, black circles), while TAVFX is down over 12% (red circles), with the Russell 1000 Value Index down 12%. Figure 19 compares returns since WGRNX’s inception and each fund’s current two top sector bets. I am sorry Mr. Whitman, but 63% is too much of a wager on financials—or on any sector. Mr. Winters' 34% weighting to consumer goods is near my limits. TAVFX might score big on financials, but it will not be with my money.

Portfolio A is short The Rydex S&P 500 Equally Weighted ETF (RSP) and long PowerShares FTSE RAFI US 1000 (PRF). I also employ these equity samples as performance benchmarks for active managers. Since fall 2005, TAVFX has lagged both.

MBIA, Financials And The Minsky Moment

The Minsky Moment is named after the US economist Hyman Minsky. The idea holds that over long periods of economic stability, leverage tends to grow in predictable stages. This economic stability leads to a fertile environment sprouting trunks of easy credit access with little perceived risk. However, as the growth continues there seems to be a movement from moderate lending, risky lending, and finally outright irresponsible Ponzi-like lending.
Dr. Housing Bubble, July 26, 2007

Mr. Whitman might have avoided the value trap with an acceptance of Hyman Minsky’s thesis on induced business cycles. Mr. Minsky is a University of Chicago graduate who rejected the school’s almighty law of market efficiency (Modern Portfolio Theory, or MPT). According Minsky’s thesis, market prices are often driven (induced) by excessive debt creation (mal-investment) that divorces market prices from their true value. Please read Minsky’s 1992 "The Financial Instability Hypothesis."

Price distortions are common when bubbles are inflating and after bubbles bursts. During the late summer of 2007, MBI began its slide down the slippery slope of a debt-induced cycle. In 2007-2008, investors have seen many housing-related and financial stocks cascade below what Mr. Whitman saw as bargains. MBI and other monocline insurers are near the epicenter of the debt bubble, which is why investors should not bet the ranch on them. After doing some homework, speculators might spread their bets with a reasonable allocation to financials that comprises no more than 5%-10% of their portfolios (5% is in my zone).

Portfolio Implications

The Efficient Market Hypothesis assumes that market participants have access to enough information to establish a reasonable price and that on each trading day the market arbitrates fair value. However, how does the market know value when too many bidders are blinded by greed or when panic overcomes sellers? We witnessed blind greed in 1999 and fear in 2002. Now we are told that the market indexes were priced correctly during the summer and fall of 2007. At one time in 2007, the financials represented nearly 30% of the S&P 500, which is way above its historic representation. How could the market price the S&P correctly when nearly a third of its constituents had esoteric balance sheets and income statements polluted with ABS, CDOs, CLOs, SIVs and lately VIEs and auction rate securities? Did Standard & Poor's know what they were buying when they overweighted their index to financials? If not, maybe they should have asked their credit rating agency.

MPT is dependent upon transparency so the bidders and sellers can efficiently set fair prices; without it, prices might seem fair but they can be far from right. "Optimized portfolios that employ MPT often behave unexpectedly after bubbles deflate. Asset correlations that were historically weak become strong." Therefore, risk management requires investment managers to reduce leverage, reduce asset durations and overweight to high-quality securities.

Why did not more market players underweight and/or avoid financial and housing-related stocks prior to their price collapses? Those that thoroughly researched the credit bubble and restrained MPT urges did. For many others, peer pressure and career risk kept them from being active participants in the market.

MPT adherents reject Minsky’s thesis. They uphold views that all knowable information is included in daily security prices. They preach a gospel that says that the best we can do is to diversify, balance asset exposure and rebalance periodically to harvest efficient market returns.

Below is news from the Active Indexer to the MPT crowd.
"If we were all passive indexers, index values would not represent knowledge and accurate information. There would be no price discovery. Mr. Market would be an idiot! Active investors are the backbone of MPT. They are the inputs. If everyone were a passive investor, security prices would tell us nothing!"

Caution pays when risk is mispriced, which the Boys from Chicago claim as impossible. Since its first installment in July 2006, Active Indexer has been making that very claim. In the summer of 2006, we also identified May 8, 2006 as a pivot date for Mr. Market’s rotation from low-quality to high-quality assets. Thank God for Mr. Market and Mr. Minsky!

"Too Close Too The Fire To See The Smoke" Is Coming Soon

In the last issue, I promised readers that I would be offering them Too Close Too the Fire to See the Smoke. I am sorry to say that this report will not be available until sometime in April. I have uncovered more and more data/evidence that supports my view that potential losses from home values are likely to exceed $6 trillion, plus indirect losses from debt instruments and credit derivatives near $1 trillion. These losses will cause huge contractions in lending to home owners, businesses, students, and state and local governments. Hits from credit are striking blows to the economy that will knock it out (a severe recession looms).

Here Is A Preview

On Feb. 29, 2008, UBS, one of the world's biggest banks, reported banks might have to book as much as $600 billion of write-downs, in addition to the $165 billion reported to date. My research first reported in the summer of 2007 indicated that huge serial losses approaching $250 billion from banks and broker dealers were already baked into the cake. I also conducted a survey in 2006 that indicated indirect losses from debt instruments and credit derivatives would approach $500 billion if housing value losses exceeded -15% (cumulative from May 2006 price peaks). Participants at a fall 2007 Pension Plan conference were shocked at my presentation after it fostered their realization that there was a high probability for bank and brokerage losses in excess of $500 billion. They are now adjusting to a new comfort zone because $400 billion-$600 billion is the present consensus.

I am very indebted to Eric Janzen, the founder of, for encouraging me to initiate research on the credit bubble via the publication of Peak Risk in May 2006. He, Dean Baker at, Nouriel Roubini at and Chris Whalen at have all contributed to my research. Too Close Too the Fire to See the Smoke will first be published at with a link found in my next issue of Active Indexer.

Portfolio Adjustments

Now that I have irritated hedge fund managers, a star manager and the MPT crowd, it is time to turn to trades made in Portfolio A since November 26, 2007, which was our last report date. Twelve percent of our trades were annual rebalancing adjustments that are done during the first six weeks or so of each New Year. Twenty-one percent were newly established positions in the British pound (FXB, short), basic material shares (SMN, short) and the U.S. dollar (UUP, long). UUP was quickly sold within three weeks after it was purchased. Six percent were additions to existing shares in oil service companies (OIH) and health care (VHT). We also reduced exposure to short-term Treasury Notes (SHY) by 14%. Trades done since November 2007 have resulted in portfolio turnover of 53%. Gross exposures declined from 169% to 163% and have been 159%-169% over the past 12 months.

Figure 22 shows equity derived Beta exposure at 78% with Non-Beta exposure at 85% for a -7% net Portfolio Beta. Beta themes are played through high- and low-quality stocks. The portfolio expresses Non-Beta through Anti-Carry Trades and Weak/Strong Dollar positions. Our fundamental research and quantitative factor analysis drives all position weightings within the portfolio. Technical overlays on each position are employed tactically and for substituting one vehicle for another to express Beta and Non-Beta exposures.

A Tactical Fundamental And Technical Trade

UltraShort Basic Materials ProShares (SMN) was our latest trade made on February 29, 2008. It represents 6% of assets and 12% of gross portfolio exposures. We are very concerned about a severe correction in gold, gold stocks and energy sector positions because of their economic sensitivity. Rather than selling these shares, it is wise to employ SMN.

SMN is short 200% a basket that is 56% Chemicals and 8% Paper products, which are very negatively impacted by high energy costs. The profit margins in these industries are hurt badly by $100 + crude ($WTIC) prices (beta factors invert). The underlying stocks in SMN are also overvalued and overbought, so the timing is good on a fundamental and technical basis. We are using SMN to tactically hedge gold and inflation hedges, which are in secular advances but are subject to severe cyclical declines.

It is clear from Figure 20 that we reversed course quickly in UUP. Portfolio A’s positive return attribution has at times been dependent upon a weak dollar (not overly dependent). In early February, technical readings indicated that the greenback might reverse its downtrend with a sharp countertrend rally. However, near the end of the month, the dollar broke down again, and we sold UUP.

There is a lot to balancing Offense and Defense. Too much coverage does not help. It is time to end what never ends.



1 The Leuthold Core Investment Fund (LCORX) is one of the best strategic asset allocation funds in our industry. LCORX rates five stars by Morningstar.

2 Michael H. Steinhardt (born December 7, 1940 in Brooklyn, New York) was one of the first prominent hedge fund managers. He founded Steinhardt, Fine, Berkowitz & Co., a hedge fund, in 1967. Steinhardt averaged an annualized return for his clients of 24.5%, after a 1% management fee and a "performance fee" of 15% of all annual gains, realized and unrealized, nearly triple the annualized performance of the S&P 500 Index over the same time frame.

3 Victor Sperandeo, Trader Vic II, Principles of Professional Speculation, John Wiley & Sons, New York, NY, 1994.

4 Robert J. Shiller also employed this form of normalized earnings to account for the variance of earnings during business cycles in his book, Irrational Exuberance 1st and 2nd Editions, Princeton University Press, Princeton, NJ, 2000 and 2006.

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