Buy And Hold What?

June 24, 2009

The odds of a double-dip recession are growing. Emerging markets and corporate bonds appear vulnerable. But some areas look attractive.


We are more than half of the way through 2009. The year began with a failed stock rebound and a low-quality debt rally off the November 2008 lows. And despite a rally that started in March, troubling signs still remain.

The experience of past financially led, synchronized global recessions makes it likely that our recovery will be brief. Indications are that the current rebound will last no more than three quarters with a relapse into recession sometime after the second quarter of 2010.

Most troubling is the difficulty that we will have with exporting our way out of this recession after our government stimulus wanes. Our continued high dependence on the financial sector for growth, extreme consumer indebtedness and our low savings rate also enhance the odds of a double-dip recession (forming a W shape) similar to the pattern seen during the early 1980s.

Our scoring of the Chicago Fed National Activity Index and the Conference Board’s consumer confidence indicators are improving but remain in negative territory. The Institute for Supply Management Index also has improved to levels that indicate low but positive future economic growth. The Capital Economics Recovery Index (CERI) also has improved. CERI puts the odds at 1 in 3 that our recession will end before year-end 2009.

Where Is Value?

We have witnessed the greatest earnings crash in history. Recent operating earnings estimates are worthless, just as they were from 1998 to 2002. Last year’s estimates were near $81 for forward S&P earnings. They ended 2009 Q1 at $7.21 on a 12-month reported basis. The S&P 500’s reported earnings per share for the 12-month period ending in September 2009 has been estimated by Standard & Poor’s to be negative (at a loss of $2.09 EPS) for first time in the index’s history.




At its recent high near 950, the S&P 500 registered a trailing price-to-earnings ratio (P/E) of 132.

During times of de-leveraging, real gross domestic product growth usually ranges 1.5% to 2.5% for three to five years. At the same time, median P/Es revert to 12 and risk premiums fall to 4%. My estimates are for 12-month forward earnings on the upside at $55, at a median of $45 with a downside target at $30.

If these estimates are realized with the S&P 500 at a level of around 950, forward P/Es will be near 17, 21 and 27—which are rich when the S&P’s low dividend yields and lackluster earnings growth are factored into valuations.

Given the high degree of economic uncertainties—a high PIS (price index score), low visibility for earnings (with corporate annual default rates expected to be near 13% to 15% by 2010 Q2)—I’ve got to wonder what is worth buying and holding onto at this point.




More Bubble Trouble

At this time, I am ignoring short-term bullish trends in the equity markets in favor of long-term fundamentals.

The markets are at risk of exploding to higher prices that are even more detached from reality than they are now. Our portfolio, the Arrow Insights 75/50, has reduced its gross holdings by 21% after selling 26% of long and 2% of short Treasuries (TSY) positions over the past four weeks.

Asset Inflation Coming Into Play

Our biggest asset management problem is asset inflation. There is too much money chasing too few assets issued by entities with insufficient income to pay their debts and still offer high earnings growth.

Currently we are seeing a replay of the 2007-2008 easy money-driven commodity and resource inflation stemming from the unintended consequences of the Fed's attempts at bailing out financial and industrial firms. Speculation, driven by easy money, is also divorcing asset prices from fundamentals.

Two negative unintended consequences are high gasoline prices and mortgage rates. Gasoline was at $1.62 in December 2008. It is now at $2.70 a gallon, while mortgage rates are approaching 5.4%. Higher gasoline and higher mortgage payments will strain consumer spending and dampen a home price recovery.

Our current crisis has had four waves: the collapse of a debt bubble; the bursting of a housing bubble; systemic financial system risk; and an economic recession.

The fifth and final wave will be a three- to five-year period of high corporate credit defaults with the risk of a U.S. currency and a government debt crisis.

Our position is that Treasury bonds are in a sort of “make believe” state and that corporate bonds have gotten ahead of themselves—as have domestic and foreign securities.

Emerging market investors are ignoring post-financial crisis lags more so than other indices, while the U.S. technology and health care sectors via the Nasdaq 100 are favored, given the index’s current value and long-term fundamentals.

Gold and gold stocks are no longer undervalued but they continue to hedge inflation risk and U.S. dollar risk better than other asset classes, which is why they comprise a large portion of our asset base.

Our ultra-short and outright short tactical hedges are traded over a short time horizon. They are positioned for expected declines of 10%–25% in our beta holdings and gold stocks.








Portfolio Convictions

Figure 1 above is composed of a focused list of indexes and assets classes and corresponding ETFs. Returns are through May 29, 2009.

The AI 75/50 portfolio weightings are labeled in the third column. Red highlights are for sectors that were shorted through 2x inverse ETFs (also red in Figure 2). Our long ETFs are either overweight (OW) or neutral weight (NW) relative to the Dow Jones Global Index.



A Closer Look

The AI 75-50’s primary objective is to capture 75% of the S&P’s upside and 50% of its downside, which requires us to hedge beta nimbly while maintaining core beta (equity and bond exposures). The portfolio’s 14.4 annualized standard deviation (ASD) is much lower than that of the S&P’s volatility since the market peaked in October 2007.

We have been very active since the end of May. We sold most of all gains made since the end of February 2009 in emerging market stocks, gold stocks and oil service stocks. Since May 28, we sold shares totaling 18.1% of our gross exposures. Figure 3 lists recent ETF and closed-end fund (CEF) trades.




Here are the funds with the percent sold for each: some 3% of the iShares MSCI Brazil Index (NYSE: EWZ); another 1.7% of the SPDR S&P Emerging Middle East & Africa ETF (NYSE: GAF); about 6.8% of the Market Vectors Gold Miners ETF (NYSE: GDX); another 2.7% of Templeton Global Income Fund (NYSE: GIM); roughly 1.7% of the Market Vectors Agribusiness ETF (NYSE: MOO); another 1.6% of the PowerShares Dynamic Oil & Gas Services ETF (NYSE: PXJ); and 3.3% of the Templeton Dragon Fund (NYSE: TDF).

June 8 was a risk-reduction day. It is not customary to sell core holdings. In the fall of 2008 and early winter of 2009, we purchased most of our high beta stocks. Back then, we did not have a strong fundamental basis for adding Nasdaq 100 exposure through the PowerShares QQQ (Nasdaq: QQQQ).

We do now, which justifies the selling of core assets. Technology and health care stocks have low external debts as well as high export growth, which historically have produced equity stars during recoveries from financial-crisis-led recessions.



John Serrapere works on research and consulting projects through Arrow Insights. He welcomes comments and suggestions for future columns at [email protected].

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