Secular Bears Have Cyclical Rallies

September 09, 2009

Tech and energy stocks might be the way to go for now. But don't ditch natural gas and utilities as value plays at some point, says analyst.

 

It is highly likely that a new secular bull market began in emerging markets in late November 2008. This does not mean that we do not have to be on alert for signs of renewed weakness in developing markets.

At the same time, there are many economic problems central to the systematic structure of our global trading partnerships. These problems are so ingrained that any new uptrend lasting long term in developed stock markets seems remote at this point.

But some areas of opportunities might be showing signs of opening. Recently, the ratio from dividing crude oil futures by U.S. natural gas futures (NG) prices reached its widest margin ever at 24.5 to 1. This was the highest ratio since the Nymex gas contract began trading in April 1990. Historically, it has varied between 6.5 to 1 and 10 to 1. In 2009, natural gas demand is plummeting and new onshore gas production from shale rock is setting production records.

As a result of such factors, generally we are buying assets showing strong relative strength to broader indices -- like the PowerShares QQQ (Nasdaq: QQQQ) -- after adjusting our portfolio beta on June 8 back to a more neutral weighting. We also are buying more of the JP Morgan Alerian Energy MLP Fund (NYSEArca: AMJ) on weakness.

At some point, being long NG, NG utilities and MLPs such as AMJ makes sense.

Another market to keep an eye on is mortgages. Alan Boyce is a business partner with George Soros and an expert on the mortgage market. Recently, he informed me that mortgage re-workings and the absence of marking assets-to-market would mute reported bank losses resulting from a huge wave of pending mortgage resets that hit in May 2010.

In summary, the recovery is likely to be anemic and below trend in developed markets. And there's a big risk that the debt bubble might hit the wall again in 2010, which raises the risk of a double-dip recession. We are long both reasonable and undervalued assets with strong relative price strength. We're also long assets with scarcity-resource value, such as AMJ. We are also long foreign regions and domestic sectors, such as QQQQ (soon), which benefit from their respective export markets and low debt burdens.

The British Broadcasting Company recently reported that China reduced its holdings of U.S. Treasury debt (TSY) by 3 percent in June 2009, the largest margin in nearly nine years. This move reaffirms our earlier view that China is worried about the value of its TSY positions. Recall from our earlier columns that the Chinese and other central banks have been shortening their maturities to a risk-adverse inflation posture.

Portfolio Exposures & Convictions

Figure 1 is composed of a focused list of indexes and assets classes and corresponding ETFs. Returns are through July 31 and Aug. 31. 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 equity ETFs are either overweight (OW) or neutral weight (NW) relative to the Dow Jones Global Index. The bond allocation is managed opportunistically and to enforce our desired risk exposure without reference to a bond index.

Secular-Bears-have-Cyclical-Rallies_fig1

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AI Portfolio Performance (Objectives should be evaluated over 36-month periods)

Like the Hedge Fund Research Global Hedge Fund Index (HFRX), AI’s secondary objective is to provide an absolute return (consistently positive return). As of Aug. 31, hedge funds are down -18.8 percent while the AI 75-50 Portfolio is up 12.6 percent since the S&P 500’s peak in October 2007. The AI 75/50 model has outperformed its benchmark, the HFRX and the S&P 500 during all periods shown in Figure 3.

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AI 75-50’s primary objective is to capture 75 percent of the S&P’s upside and 50 percent of its downside, which requires us to hedge beta nimbly while maintaining core beta (equity and bond exposures). The portfolio’s 13.6 annualized standard deviation (ASD) is higher than that of the HFRX, but much lower than that of the S&P’s volatility since the market peaked in October 2007.

Performance, Recent Trades, Open Orders and Current Positions

We were up 0.6 percent for the month in July 2009.

We were down -1.2 percent for the month in August 2009 with a net year-to- date (YTD) return of 14 percent.

In July 2009, we made six trades. In August 2009, there were ten trades.

Figure: Option Trades

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On July 1, we bought 5 long S&P 500 puts (SPXSO) with a strike price at $875. On July 18, SPXSO expired with no value. On Aug. 22, 5 long S&P 500 (SPXTO) with a strike price at $875 expired worthless.

Figure: ETF & CEF Trades

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On July 27 and July 30, we closed 8 percent of our short exposures after adjusting for leverage account in double inverse ETFs, namely the ProShares UltraShort MSCI EAFE (NYSEArca: EZU) and UltraShort Consumer Services ProShares (NYSEArca: SCC).

On July 27, we also covered 10 percent of our direct short positions in the iShares MSCI EURO Zone Index and the iShares Russell 2000 Index (NYSEArca: IWM).

Half of the iShares iBoxx High Yield Corporate Bond ETF (NYSEArca: HYG) was sold on July 31 (4.7 percent of the portfolio). We will review why in our next column.

We sold all shares of the PowerShares Crude Oil Double Short ETN (NYSEArca: DTO) on Aug. 4.

We replaced most of our short equity exposure with being long S&P 500 volatility futures via the iPath S&P 500 VIX Short-Term ETN (NYSEArca: VXX). We will review this strategy in our next issue. We increased our VXX exposure from slightly less than 6 percent from a purchase made on July 27 to nearly 21 percent through purchases made on Aug. 5, Aug. 14 and Aug. 27.

On Aug. 25 and 26, we sold our final shares of SCC and the ProShares UltraShort MSCI EAFE Fund (EFU). These sales represented 10 percent of portfolio exposures after each fund’s imbedded leverage.

On Aug. 27, we shorted shares of the Nuveen Real Estate Income Fund (JRS), a closed-end fund of low-quality real estate investment trusts (REIT). This trade added 4 percent in short equity exposure. We will extensively review how and why we selected short REIT candidates in the September issue.

Open orders: We have orders to initiate a 7.5 percent position in QQQQ at $37 plus 7.5 percent more at $35. There are additional orders to buy 6 percent more of AMJ half at $23 and half at $22.50. We also will sell 10 percent of TBT at $64 if we ever hit this price (rebalance).

Strategic & Tactical

Since May 2009, we have a better balance between inflation and deflation hedges. So far, our lost opportunity cost has been nearly -5 percent. Although we reduced risk, we would have been better off doing nothing since then. The Arrow Insights 75/50 Portfolio was up 19.3 percent at the end of May. We would still be up about 19 percent absent all trades since May. For what it is worth, we are up 1.3 percent during the first two days of September while the S&P 500 is down -2.5 percent (Figure 5).

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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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